1. DIPPING INTO THE FOREIGN MARKET WATERS – HOW CAN ONE
MAXIMIZE THE EARNING POTENTIAL OF FOREIGN CURRENCIES
Ladies and gentlemen, good morning.
The topic assigned to me is something that seems to be more within the field of
competence of currency traders and analysts (which I am not) as it delves into
the analysis of opportunities obtaining in foreign currency trading and investment
(or for some, speculation). As an erstwhile international investment banker based
in Europe but now domesticated in the Philippines dabbling in university lectures
and LGU finance business, I will tread on this highly interesting subject matter
with a certain degree of trepidation – knowing that my direct exposure to actual
currency trading has now become, what I call, a vague recollection of my
younger days. But then, I can honestly claim that my tacit knowledge hewn from
such experience continues to be polished through sustained interaction with my
banking colleagues here and abroad – not to mention, my regular reading of
treasury articles and newsitems and my intermittent forays into the currency
markets. Given that backdrop, I hope to come out of this presentation unscathed.
I will take a discourse on this topic from the point of view of an investment banker
with the intention of giving you some insights on how to better position
yourselves in foreign currency trade and investment. The message is directed to
both corporate and individual audience.
My discussion will be divided into three (3) sub-topics, namely:
1. a new look at currency management
2. pattern of best practices in international treasury operations
3. assessing opportunities and risks
A New Look at Currency Management –
Investment activity in foreign currencies has not been as active in the Philippines
as one would find it in Hongkong or Singapore. If at all, we know foreign currency
investment in terms of dollar deposits, FCDU accounts, or taking a position in
foreign currency denominated Philippines debt instruments. Even the recently
introduced investment product called Unit Investment Trust Fund (UITF), being
peddled by Philippine banks these days, does not contain any significant
diversification in foreign currency investment.
Yet the significance of an active currency management and opportunities in
currency trading or investment cannot be overemphasized both from the
corporate and individual perspective.
Consider alone the following situation.
2. Over the past seventy five (75) years, the US markets have yielded the following
inflation-adjusted annual average returns:
Balanced Portfolio 4.5%
On the other hand, major currencies have fluctuated at an annual average of
12% per year for the last ten (10) years. We can therefore reasonably conclude
that, given this historical trend, the exchange-rate fluctuation can be a source of
tremendous opportunity – or a significant loss.
This was in fact the strategic consideration of the first investment house I joined
in the 70s when it pioneered in multi-currency operations from out of Hongkong,
actively participating in the spot and forward markets and exploiting arbitrage
opportunities in different markets. This posture gave us enough flexibility to better
manage our foreign currency portfolio and offer our clients a wide array of
investment products, other than those available in the domestic market.
Active currency management suggests that the disciplines applied in managing
return and risk for equities and bonds should also be harnessed to optimize yield
and mitigate risk on currency exposure. Shifting from a passive to an active
posture necessitates debunking two myths about currencies, namely:
a) that currencies do not matter; their behavior is a given; and
b) that the behavior of a currency is correlated to the relative performance of
In recent study made by TAL Global Asset Management Inc., a Canadian
currency specialist, it was noted that since 1991 the monthly relative returns for
equities have averaged 10%, while for currencies and bonds, they registered an
average 5% and 2% respectively. From a global asset-allocation point of view, it
implies that currencies have the potential to explain about 30% of returns. It is
rather odd for a good number of institutions and managers to actively manage
their position in equities and bonds, but not in currencies. At this level of relative
returns, currencies after all do matter.
Most treasury managers and individuals still benchmark their risk and return in
the management of currencies on the basis of the underlying assets. This idea
emanates from the conventional wisdom that capital flows chase the best
performing markets, presumably forcing up currency values. On the other hand,
recent studies suggest that for the period 1993-2003 there is almost an
insignificant correlation between currencies and equities performance, averaging
-0.2, while with bonds, correlation coefficient averaged at an equally insignificant
3. level of 0.2. This suggests that we cannot just “flow with the tide”. Obviously, the
recent peso appreciation is not a function of an improved Philippine stock market
and/or the local bond market. Improved fiscal measures coupled with increased
OCW remittances largely accounted for this peso upswing. Somehow, in the light
of these findings, one has to raise his awareness and capability in managing
Best Practices in International Treasury Operations –
It might not obvious for some, but optimizing earning potential in foreign
currencies resides in the very process or practices being observed by the
treasury officer or individual investor. Whether you operate as a firm or an
individual, you should look at your liquid assets in terms of the nature and degree
of exposure, the performance quality, and revenue-cost efficiency.
Those who have taken this kind of strategic posture have been profiled as
sharing certain best practices in international treasury operation. This is the
overall finding in the research done by AnswerThink Consulting Group USA.
Let me highlight some of the more significant best practices common among
companies with excellent treasury operating units:
1. The finance function is centralized, even as decentralization in other
operating business units is being pursued. Money is a non-contextual
asset and, therefore, it thrives largely on universal principles and
procedures. A good example is Hard Rock Café, where the London head
office takes charge of the formulation of global policy and treasury
architecture, but certain leeway on specific policy implementation or
interpretation is given to subsidiaries or branches.
2. Treasury roles and responsibilities are clearly defined with information flow
delivered fast and effective. The globalized and dynamic currency markets
require fast decision making. Getting the right information to the right party
executing a currency transaction can make a great difference between
success and disaster. Banks with global presence like Deutsche Bank and
Citibank have taken this unique character to high level and global
corporations like Nestle and Shell are not far behind.
3. An effective risk management system is put in place as risk analysis is
integral to treasury function. The usual risks associated with transaction
and translation exposure management are perfunctorily assessed.
Forwards and futures contracts are consolidated and monitored on a
regular basis. Similar to project risk, currency risk exposure is ranged
against other factors such as political or sovereign risk and regional
4. 4. Significant amounts of resources are invested in information gathering,
knowledge sharing and communication. Capital outlay in the latest
telecommunication hardware and architecture is not viewed as cost, but
as an investment in quick information access, better performance delivery,
and knowledge accumulation.
5. Treasury people act as partners of other business units. The best-in-class
companies have stopped the practice of keeping their treasury personnel
in silos. The image of snooty moneymen in the organization is passé for
these firms. The treasury function has become a dynamic part, particularly
in matrix type of organizations.
6. Structures and work flow are kept simple. Best-in-class companies have
standardized procedures in currency management and payments process.
At the same time, they have leveraged banking relationships for
economies of scale.
7. Only people with experience and expertise are kept in the department.
Neophytes are trained in other departments first before they get exposed
to treasury operations.
8. Continued improvement is the name of the game. Process innovation is
always being sought to achieve greater efficiency. Choosing and re-
evaluating financial partners (e.g. banks and investment advisers) on a
sustained basis characterize a best-in-class treasury department.
Building Opportunities and Mitigating Risks -
At this juncture, I am hesitant to give a definitive prescription that is supposed to
ensure a healthy risk-reward mix for one’s currency portfolio. To do so, I am
afraid, will be a case of intellectual braggadocio or irresponsible posturing. How I
wish there is a foolproof mathematical formula that will accurately forecast
currency trends. But then, even astute experts like Kenichi Ohmae have realized
the growing inefficiencies of traditional models to prognosticate or approximate
economic trends. Could this be the reason why even some rocket scientists in
Wall Street advocate a return to social science disciplines to explain away some
phenomena in business and economics? I think so.
Be that as it may, I will nonetheless give you my two-cent worth of advice. Keep
yourselves well grounded on the basic principles of investment – safety,
profitability, and liquidity. Make sure that the currency you are taking a position
on is free from any significant capital loss over the contemplated investment
period. The earning potential from currency appreciation and interest rate should
more than compensate for the risk of a reversal. Lastly, be sure that your
investment will not get stuck in a currency export ban, as what happened in Libya
5. For corporate portfolios, matched hedging and diversification may be the basic
guideposts. A healthy mix of US dollar, Euro and Japanese yen should be staple
items. Needless to say, the mix should have bias towards currencies for which
the firm will have greater need in the immediate future (e.g. payment of import
bills). Partial hedging should also be taken into consideration, even under a
peso-appreciating regime. Any currency exposure should however be subjected
to portfolio optimization techniques in order to quantitatively assess the risk
profile of such exposure. Several approaches are available for implementation,
but to me the most effective is the portfolio optimizer. This technique evaluates
all currencies existing in the portfolio and calculates the expected gain/loss and
portfolio risk based upon the spot/forward rates and relative volatilities/
correlations with respect to a major currency, say, the US dollar. The optimizer
indicates which currencies to hedge or keep open and which ones to fully or
Individuals with substantial savings should indeed consider currency
diversification. Those who are not content keeping their money in their FCDU
account may try a good mix of US dollar, Euro and Yen denominated equities
and fixed-income securities. In any case, it would be advisable to obtain
professional advice from investment bankers and portfolio managers well versed
in currency investment. However, to avoid being ripped off by smooth operators,
it is always safe to entrust your investments with recognized portfolio managers,
trust funds or banking institutions.
The growth of online currency trade has opened up a new and exciting way of
directly participating in the global currency markets. If you have sufficient time
and resources and have the passion to learn the intricacies of online trading, it
may be a good source of opportunities for you. But then, it is advisable that you
check and double check on the people and institution behind the portal before
you enter a transaction and swipe your payment.
With the fast-paced development in telecommunication infrastructure and
technology coupled with the scaling down of barriers to capital transfers and
notwithstanding the institutional checks made in good measure to curtail money
laundering, the volume of currency trade will continue to increase. Currency
market remains the single biggest sector of the global financial system,
outstripping the activities in the stock and bond markets. Even as it has been the
playground of big-ticket players, the advent of online trade will gradually enable
individual investors to directly participate in the global currency trade and
Atanacio DA Panahon II
Interactive Financial Services Inc.