03/02/2008

An Introduction to the Foreign Exchange Market

In terms of turnover, the foreign exchange market is the largest financial market in the world with a wide variety of participants. Movements in rates can be swift and sharp, having important implications for both the institutional and the private investor.

In its last survey of the market in September 2007, the Bank of International Settlements estimated daily average turnover to be $3.2 trillion. Traditionally the largest participants have been multinational banks who provide foreign exchange pricing for their corporate customers needs and who also take active positions in the markets themselves. However, over the past ten years there has been a significant increase in volume from institutional investors in particular hedge funds who are entering the market largely for speculative purposes. Central banks have also become more active in managing their reserves via the set up of Sovereign Wealth Funds. Private investor flows remain very small.

Exchange rate levels are determined by many factors – some short and some longer term. The traditional longer term academic approach to forecasting movements is the Purchasing Power Parity (PPP) theory. The idea is that an exchange rate of £1=$2 would mean that a basket of goods bought in Scotland for £10 could also be purchased in America for $20. If the goods in America cost $21 the exchange rate should, over time, move towards £1=$2.10.There are many more sophisticated derivatives of this theory used by forecasters but they are all based on this principle.

It is, however, possible for an exchange rate to vary significantly from its PPP equilibrium level due to a variety of other shorter term factors which either in isolation or combination influence exchange rates. These include relative economic outlook, relative interest rates and changes in expectations of future interest rates, central bank activities, merger and acquisition flows and domestic politics. A good example of such a PPP deviation is the long term elevated GBP/USD rate which remained above £1=$2 for the second half of 2007 when the PPP valuation model implies the rate should be around £1=$1.67. This was largely due to the UK’s better perceived relative future economic performance, higher interest rates and merger and acquisition flows.

Exchange rates and their movements are important to investors for two main reasons. The first is to look at how the effects of exchange rate movements affect returns from other asset classes. A good example is to look at the Sterling based returns of a UK domiciled investor with money in a Japanese bond fund. Japanese interest rates have been very low for several years with 10 year bond yields averaging circa 1.7% in 2007. In the second half of 2007 the Sterling/Japanese Yen rate moved 15% (from a high £1=251 to a low of £1=213.5) implying that the bulk of the absolute return in Sterling terms was actually due to Yen appreciation and not the returns on the underlying asset. All overseas investments have an element of currency risk which can add to or subtract from investor returns.

The second major impact that exchange rate movements can have is to actually look at the foreign exchange market as an asset class in it own right. Over the past ten years there has been increasing institutional interest to look for a way of both increasing returns and looking at ways of diversifying investments away from the more traditional markets such as bonds, stocks and property. Currency funds have benefited from this as foreign exchange returns are largely uncorrelated with the traditional market returns and the currency market is large and liquid. There are many different styles of Currency funds with trading decisions determined by a variety of factors such as relative interest rates, systematic trading models or a valuation based approach.

Over the past year the foreign exchange markets have moved from a position of low to higher volatility. In the first half of 2007 exchange rate trends were broadly based on relative interest rate differentials with participants selling low interest rate currencies such as the Japanese Yen or the Swiss Franc and buying higher interest rate currencies such as the Australian or New Zealand Dollar and emerging market currencies. Sterling also benefited from this so called “carry trade”.

However, as volatility has increased following the start of the global credit crunch and the subsequent economic slowdown, the positive returns from carry trades have diminished. There has been a general trend of risk aversion, repatriation and the pursuit of safe haven currencies. Over the past six months Sterling has depreciated approximately 4.5 % against a basket of currencies of its major trading partners and significantly more against the Japanese Yen and the Swiss Franc. This general trend of Sterling depreciation is likely to continue at least through the first half of 2008 as UK interest rates decline coupled with deterioration in fiscal and current account balances. Depreciation will continue to be most aggressive against the Yen and Swiss Franc and it is highly doubtful that Sterling will return to the heights of £1=$2.11 seen in November 2007, a slide towards $1.90 is more likely.

The foreign exchange markets are large, liquid and whose movements can have a significant impact on investor’s absolute returns. The market is increasingly attracting investors looking for alternative investment opportunities with uncorrelated returns to the more traditional investment areas.

Simon Wood, Investment Director – Currency, Standard Life Investments

This article was published in Scotland on Sunday on 3rd February 2008

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