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What do you think of the Euro? How about the Japanese yen? Are you expecting the Thai baht to depreciate in value versus the Brazilian real? Speculators, central banks, corporations, governments, financial institutions, and other constituencies ask similar types of questions every day. The largely over-the-counter global foreign exchange markets (no central exchange) are ubiquitous, measuring in the trillions. The BIS (Bank for International Settlements) computed the value of traditional foreign exchange markets at $3.2 trillion in April 2007. Thanks to globalization, these numbers are poised to expand even further. Like other futures markets (think oil, gold, or pork bellies), traders can speculate on the direction of one currency versus another. Alternatively, investors and businesses around the world can use currency futures to hedge (protect) or facilitate international trade.

Without getting lost in the minutiae of foreign exchange currency trading, I think it’s helpful to step back and realize that regardless of strategy, currency, interest rate, inflation, peg-ratio, deficits, sovereign debt, or other factors, money will eventually migrate to where it is treated best in the long-run. When it comes to currencies, it’s my fundamental belief that economies control their currency destinies based on the collective monetary, fiscal, and political decisions made by each country. If those decisions are determined imprudent by financial market participants, countries open themselves up to speculators and investors exploiting those decisions for profits.

Currency Trading Ice Cream Style

As mentioned previously, currency trading is predominantly conducted over-the-counter, outside an exchange, but there are almost more trading flavors than ice cream choices at Baskin-Robbins. For instance, one can trade currencies by using futures, options, swaps, exchange traded funds (ETFs), or trading on the spot or forward contract markets. Each flavor has its own unique trading aspects, including the all-important amount of leverage employed.

The Carry Trade

Similar to other investment strategies (for example real estate), if profit can be made by betting on the direction of currencies, then why not enhance those returns by adding leverage (debt). A simple example of a carry trade can illustrate how debt is capable of boosting returns. Suppose hedge fund XYZ wants to borrow (sell U.S. dollars) at 0.25% and buy the Swedish krona currency so they can invest that currency in 5.00% Swedish government bonds. Presumably, the hedge fund will eventually realize the spread of +4.75% (5.00% – 0.25%) and with 10x leverage (borrowings), the amplified return could reach +47.5%, assuming the relationship between the U.S. dollar and krona does not change (a significant assumption).

Positive absolute returns can draw large pools of capital and can amplify volatility when a specific trade is unwound. For example, in recent years, the carry trade from borrowing Japanese yen and investing in the Icelandic krona eventually led to a sharp unwinding in the krona currency positions when the Icelandic economy collapsed in 2008. High currency values make exports less competitive and more expensive, thereby dampening GDP (Gross Domestic Product) growth. On the flip side, higher currency values make imported goods and services that much more affordable – a positive factor for consumers. Adding complexity to foreign exchange markets are the countries, like China, that artificially inflate or depress currencies by “pegging” their currency value to a foreign currency (like the U.S. dollar).

Soros & Arbitrage Vigilantes

Hedge funds, proprietary trading desks, speculators and other foreign exchange participants continually comb the globe for dislocations and discrepancies to take advantage of. Traders are constantly on the look out of arbitraging opportunities (simultaneously selling the weakest and buying the strongest). Famous Quantum hedge fund manager, George Soros, took advantage of weak U.K. economy in 1992 when he spent $10 billion in a bet against the British pound (see other Soros article). The Bank of England fought hard to defend the value of the pound in an attempt to maintain a pegged value against a basket of European currencies, but in the end, because of the weak financial condition of the British economy, Soros came out victorious with an estimated $1 billion in profits from his bold bet.

I’m not sure whether the debate over speculator involvement in currency collapses can be resolved. What I do know is the healthier economies making prudent monetary, fiscal, and political decisions will be more resilient in protecting themselves from arbitrage vigilantes.

Source: Foreign Exchange, The Carry Trade, And Arbitrage Vigilantes