Explore other key resources on the Currency Alpha opportunity
Focusing on Fundamentals
External Imbalances as a Driver of Exchange Rates
Unconventional Policy Response to the Financial Crisis: Implications for the Currency Markets
Active Currency Management: The Unexploited Alpha Opportunity
Preparing for the Inevitable: A Stronger US Dollar
The New Case for a Free Lunch in Currency Investing
Please describe to us the basic form of currency management—the carry trade.
Giulio Martini, CIO of Currency & Quantitative Strategies: The idea of a carry trade refers to is a strategy that borrows in a low yielding currency, for instance the Japanese yen today where short term interest rates are 0%, and invests in a higher yielding currency such as the Australian dollar where short term interest rates are 4%. And the objective of a carry trade is to pick up that interest rate differential between two countries.
When does carry trade not work?
Giulio Martini: The exchange rate can move to offset some of that positive interest rate differential. For example if the yen in the above question were to rise against the Australian dollar it would offset part of that 4% interest rate differential that an investor was earning. And if it rose by more than 4% it would offset the entire interest rate differential. Therefore there is downside risk in a carry trade that comes from exchange rate moves in addition to the interest rate differential. It is the sum of those two parts that constitute your total return on a carry trade.
Is currency management alpha or beta?
Giulio Martini: It’s both. Beta is compensation that investors receive for taking exposure to systematic risk premiums in different markets that cannot simply be diversified away. There is a beta element in currency returns because there is a risk premium embedded in interest rate differentials between countries. Alpha occurs when a manager can add over and above that basis risk related return by using whatever tools they can bring to bear to pick more attractive currencies relative to that basket and avoid less attractive ones. Therefore currency investing really has both elements, the alpha comes through manager skill, and the beta element comes through taking systematic exposure to high yielding currencies.
What is “Better Beta”?
Giulio Martini: Better Beta is one of my favorite phrases. “Better Beta” offers the potential to outperform cash by a similar amount as other high return securities but also with less volatility and downside risk. Let me provide an example: if you look at equity markets in the long term, they outperform cash by about 500 basis points a year, but to get that premium you have annual volatility of about 15% and you have downside risk of 50% plus in years when things go really badly. In currencies I think we can produce that same 500 basis point premium over cash with volatility of about 6-7% and downside risk of about 15%. So in my mind currency offers this “better beta” relative to stocks.
To what extent would you consider currency management re-risking or de-risking?
Giulio Martini: Well in my mind you can consider currency management as a de-risking kind of strategy if it replaces assets that have higher volatility for the return premium they offer. Another aspect of investment risk that currency can be considered de-risking in relation to is inflation. Currency strategies actually respond positively to rising inflation and can be thought of as de-risking versus other asset categories.
Do you think all asset classes are actually applicable in terms of funding a currency mandate?
Giulio Martini: Well I think if you just go by the numbers that adding a currency component to diversified portfolios that contain stocks, bonds, real estate, commodities, all the things that investors have been interested in over the long term and in recent years, it makes a lot of sense to add a currency strategy to that. Now the fact that it’s something relatively new means that it probably should be added modestly so that people can gain experience with it and over time see that it can deliver these attractive risk and return properties. But most definitely currencies can be added to portfolios to really end up producing better risk adjusted outcomes together with those other assets.
You talk about currency being a modest component in an investor’s portfolio, does that mean funding is equally as simple if not modest?
Giulio Martini: It means that the degree of funding would be modest but funding is actually very flexible in a currency strategy. Because a currency strategy can really be executed without necessarily committing cash up front at the beginning of the strategy. We implement the currency strategy using what are called forward contracts. And forward contracts settle at the end of the contract term as opposed to the beginning, so there’s no need to pay premium up front as you would in the case of an option in a strategy, and also initial margin doesn’t necessarily have to be posted, provided the forward contract is less than 12 months in length it can be supported by the general creditworthiness of the borrower. And so because of that flexibility and the type of instrument used currency can be a very, very cash efficient investment.
How does liquidity and transparency fit in terms of your strategy and currency management?
Giulio Martini: The currency market is the most liquid financial market in the entire world. So for example, there are estimates that currencies trade in various forms between $2-3trn a day in value. That’s eight to ten times the size of the global stock market. Therefore the trading costs are very low in relation to costs for other assets, and that liquidity is ample enough to let you get in and out very easily. And so currency is something that we can make liquidity available on a daily basis to our investors for in our separately managed accounts, and in our co-mingled funds we offer bi-monthly liquidity with 30 days’ written notice.
Regarding transparency, we are willing to disclose our positions, with the appropriate confidentiality agreements, to those who are monitoring risk on a very frequent basis. However we cannot disclose are our aggregate outstanding positions.