Financial analyst

CURRENCY MARKETS ARE DIFFERENT

Throughout this blog, we have looked, albeit from varying perspectives, at the governing dynamics that drive the global currency markets. If we have learned one thing, it is surely this, that the currency markets are by their nature predominantly “speculative”. That is to say, the majority of currency market participants are what we would define as “speculators”, using the definition of this blog for currency speculation as the trading or investing in currencies without any underlying, attached asset. The predominance of speculation within currency markets is neither a good nor a bad thing. On the one hand, it provides needed liquidity for those aspects of the economy deemed productive rather than speculative. On the other hand, it can and frequently does lead to overshooting relative to perceived economic fundamentals.
The speculative nature of the currency markets may be an important reason why most long-term fundamental equilibrium models work poorly in trying to forecast exchange rates. At the least, it serves as an excellent excuse for those who otherwise are unable to forecast exchange rates using the traditional methods. All of this may be true, and all of it makes for a very different world from those of the equity or fixed income, markets. By necessity, these are not speculative by nature since they are themselves underlying assets relating to the economy in some way. This is not at all to suggest that speculation does not occur in equities or fixed income, for any such suggestion would clearly be foolish. The recent bubble in the NASDAQ should serve as an excellent warning for any who think these markets are always fundamentally-driven and incapable of speculative excess. That said, this same example is surely notable by its rarity. Throughout history, there have indeed been examples of speculative excess across all markets. In equity and fixed income markets, relative to “normal” conditions however, these are the exception rather than the rule. This is not the case in currency markets, where traditional economic theory has all but given up trying to explain short-term moves and longer-term exchange rate models have far from perfect results.
The dynamics of the asset and currency markets are “fundamentally” different. Therefore these risks should be dealt with separately and independently from one another. For the international equity fund manager, investing in a country is not the same and should not be the same decision as investing in a country’s currency. Eventually, they may have the same risk profile over a long period of time. However it is questionable whether the investor’s tracking error and Sharpe ratio, not to say the investor themselves, should have to go through that degree of stress!
Equally, currency is not the same as cash. An individual investor may treat currency as cash from a relative performance perspective. Unfortunately, however, such a comparison provides a false picture. Most currency market participants, and therefore the currency market as a whole, do not buy or sell currencies for the income that a “cash” description would of necessity entail. On the contrary, they do so for anticipated directional or capital gain. In other words, they are seeking to profit from precisely the risk that the investor is not hedging! It is a generalization, but nevertheless true that the reluctance to manage currency risk is far more predominant among equity fund managers thanfixed income fund managers. That may have something to do with the intended tenor of the investment, suggesting fixed income fund managers may be more short-term in investment strategy than their equity counterparts. Any such view seems greatly oversimplistic, and would require a study on its own to verify or otherwise. Many cannot manage currency risk simply because the rules of their fund do not allow them so to do. There remains however a substantial community of institutional investors who apparently have yet to be convinced by either the merits or the need to manage currency risk separately. By the end of this series of posts, it is my hope that I will have caused many within this community to at least reconsider their view as regards currency risk. To summarize this part, the way currencies and underlying assets are analysed and the way they trade are both different from each other. Consequently, the way they should be managed should also be different.