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- 1. Finance 490-402: Alternative Investments Fall 2013 Currency 1 Finance 490-402: Alternative Investments β Nov. 6, 2013 1. What is currency? 2. Foreign exchange market 3. Exchange rates 4. Currency trading styles
- 2. Finance 490-402: Alternative Investments Fall 2013 Currency β Money Supply 5 Central banks have control over the amount of money in issuance. However, the amount of money in existence at any given moment can be difficult to measure. M0 money supply: this is lowest and most liquid form of money and it only includes the actual amount of coins and paper money in circulation. Monetary base: includes M0 as well as bank reserves held with the Federal Reserve. M1 money supply: this includes M0, plus all demand deposit accounts at commercial banks. M2 money supply: this includes M1, plus all current accounts at commercial banks such as savings accounts, and checking accounts. Finance 490-402: Alternative Investments β Nov. 6, 2013
- 3. Finance 490-402: Alternative Investments Fall 2013 Currency β Monetary Base 6 Finance 490-402: Alternative Investments β Nov. 6, 2013 $0 $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 $3,000,000 $3,500,000 $4,000,000 4/1/1970 12/1/1971 8/1/1973 4/1/1975 12/1/1976 8/1/1978 4/1/1980 12/1/1981 8/1/1983 4/1/1985 12/1/1986 8/1/1988 4/1/1990 12/1/1991 8/1/1993 4/1/1995 12/1/1996 8/1/1998 4/1/2000 12/1/2001 8/1/2003 4/1/2005 12/1/2006 8/1/2008 4/1/2010 12/1/2011 8/1/2013 USD(Millions) US Monetary Base
- 4. Finance 490-402: Alternative Investments Fall 2013 Currency 8 Floating vs. fixed currencies Floating currencies are those that are allowed to trade openly, and whose value versus other currencies can change according to free market supply and demand characteristics. Fixed, or pegged, currencies are those which the issuing government manages to maintain a constant value versus another currency. This monetary system may be tied to a global reserve currency, such as the US dollar, or to a fixed amount of gold. Pegged currencies require the central bank to manage the currency (printing or buying currency, raising or lowering rates, and often enacting capital controls) in order to keep a steady exchange rate. Finance 490-402: Alternative Investments β Nov. 6, 2013
- 5. Finance 490-402: Alternative Investments Fall 2013 Foreign Exchange 9 Foreign exchange (Forex or FX) market is an exchange for the global, decentralized trading of currencies. Financial centers around the global function as centers of trade, usually via large securities dealers or commercial banks. There are several interbank electronic platforms that allow for direct, electronic trading between market participants. FX markets trade 24 hours a day, except for Saturday and Sunday (Greenwich Mean Time). The current forex markets have their foundation in the 1970s, as restrictions on currency transactions were eased and countries around the world went off the gold standard. Finance 490-402: Alternative Investments β Nov. 6, 2013
- 6. Finance 490-402: Alternative Investments Fall 2013 Foreign Exchange 10 The foreign exchange market is the most liquid market in the world. Over $4 trillion dollars worth of trading occurs each and every day. Notional amount is around $66 trillion. Foreign Exchange Markets Daily Volume ($ Bil) Forex swaps $1,750 Spot market $1,500 Forwards $475 Options $225 Other $50 Foreign Exchange, 10.4% Interest Rate, 77.3% Equities, 1.0% Commodities, 0.5% Credit Default, 4.2% Other, 6.6% Global Derivatives Notional Finance 490-402: Alternative Investments β Nov. 6, 2013
- 7. Finance 490-402: Alternative Investments Fall 2013 Foreign Exchange 11 Market Share 1 Deutsche Bank 14.6% 2 Citi 12.3% 3 Barclays 11.0% 4 UBS AG 10.5% 5 HSBC 6.7% 6 JPMorgan 6.6% 7 Royal Bank of Scotland 5.9% 8 Credit Suisse 4.7% 9 Morgan Stanley 3.5% 10 Goldman Sachs 3.1% Forex Dealer Daily Volume Finance 490-402: Alternative Investments β Nov. 6, 2013
- 8. Finance 490-402: Alternative Investments Fall 2013 Currency 12 Currencies are often divided up into two large categories: G10 and everyone else (mostly emerging markets). The G10 currencies are considered to be the most liquid markets in the world, and typically are from stable political and open economic regimes. G10 Symbol Australian Dollar AUD British Pound GBP Canadian Dollar CAD Euro EUR Japanese Yen JPY New Zealand Dollar NZD Norwegian Krone NOK Swedish Krona SEK Swiss Franc CHF United States Dollar USD EM Symbol Brazilian Real BRL Chinese Yuan CNY Columbian Peso COP Indian Rupee INR Israeli Shekel ILS Mexican Peso MXN Polish Zloty PLN Russian Ruble RUB South African Rand ZAR Thai Baht THB Finance 490-402: Alternative Investments β Nov. 6, 2013
- 9. Finance 490-402: Alternative Investments Fall 2013 Exchange Rates 13 One interesting point about currency is that there is no such thing as an independent long or short position. Any currency trade can only be defined relative to another currency. That is, all currency positions are pairs trades. These pairs trades are referred to as exchange rates. An exchange rate will be quoted as: EURUSD = 1.2897 This means that every β¬1.00 Euro will purchase $1.2897 US dollars. USDJPY = 94.5100 This means that every $1.00 USD will purchase Β₯94.510 Yen. Finance 490-402: Alternative Investments β Nov. 6, 2013
- 10. Finance 490-402: Alternative Investments Fall 2013 Exchange Rates 14 EURUSD 1.3500 4.7% EURUSD 1.2897 0.0% EURUSD 1.2500 -3.1% USDJPY 97.0000 2.6% USDJPY 94.5100 0.0% USDJPY 90.0000 -4.8% EUR weakens, USD strengthens USD weakens, JPY strengthens EUR strengthens, USD weakens USD strengthens, JPY weakens When a currency pair moves, it means one currency strengthens and the other weakens. Finance 490-402: Alternative Investments β Nov. 6, 2013
- 11. Finance 490-402: Alternative Investments Fall 2013 Currency β Spot Market vs. Forward 15 Spot market involves the immediate transfer of actual currencies. Essentially, you are exchanging the currencies for each other at the point of sale. If you hand over US dollars to a currency exchange and you receive Mexican pesos, this is the spot market. This is different than a future or forward contract, which is agreeing to exchange at a give rate in the future. Most currency trading is via spot or futures. Swaps are slightly differentβ¦ Finance 490-402: Alternative Investments β Nov. 6, 2013
- 12. Finance 490-402: Alternative Investments Fall 2013 Currency β Swap Market 16 Currency swaps are over-the- counter transactions, and unlike other swaps, they can involve the actual transfer of amounts between counterparties. This is usually referred to as an FX swap. Currency swaps will include not only the notional transfer, but also an interest rate swap as well since interest rates in the different countries will be different. A B β¬100,000 $128,970 A B β¬100,000 $128,970 2% on $ 5% on β¬ FX Swap Back-to-back Swap Finance 490-402: Alternative Investments β Nov. 6, 2013
- 13. Finance 490-402: Alternative Investments Fall 2013 Triangle Arbitrage 17 USDJPY 94.5100 $ β¬Β₯ Beginning USD $5,000,000 EURUSD 1.2897 β¬3,876,871 EURJPY 123.58 Β₯479,103,668 Ending USD $5,069,344 Finance 490-402: Alternative Investments β Nov. 6, 2013
- 14. Finance 490-402: Alternative Investments Fall 2013 Currency Performance 18 Finance 490-402: Alternative Investments β Nov. 6, 2013 40% 60% 80% 100% 120% 140% 160% 180% 200% 1/1/1990 12/1/1990 11/1/1991 10/1/1992 9/1/1993 8/1/1994 7/1/1995 6/1/1996 5/1/1997 4/1/1998 3/1/1999 2/1/2000 1/1/2001 12/1/2001 11/1/2002 10/1/2003 9/1/2004 8/1/2005 7/1/2006 6/1/2007 5/1/2008 4/1/2009 3/1/2010 2/1/2011 1/1/2012 12/1/2012 EURUSD JPYUSD CADUSD GBPUSD
- 15. Finance 490-402: Alternative Investments Fall 2013 Currency Performance 19 US Dollar Index measures the performance of the US dollar against a basket of foreign currencies. The index provides a broad measure of the relative strength or weakness of the US dollar. The index has been changed only one once, when the Euro was created subsuming several individual European currencies. EUR 57.6% JPY 13.6% GBP 11.9% CAD 9.1% SEK 4.2% CHF 3.6% Current weights Finance 490-402: Alternative Investments β Nov. 6, 2013
- 16. Finance 490-402: Alternative Investments Fall 2013 Currency Performance 20 Finance 490-402: Alternative Investments β Nov. 6, 2013 0 20 40 60 80 100 120 140 160 1/1/1976 5/1/1977 9/1/1978 1/1/1980 5/1/1981 9/1/1982 1/1/1984 5/1/1985 9/1/1986 1/1/1988 5/1/1989 9/1/1990 1/1/1992 5/1/1993 9/1/1994 1/1/1996 5/1/1997 9/1/1998 1/1/2000 5/1/2001 9/1/2002 1/1/2004 5/1/2005 9/1/2006 1/1/2008 5/1/2009 9/1/2010 1/1/2012 5/1/2013 US Dollar Index
- 17. Finance 490-402: Alternative Investments Fall 2013 Currency Styles 21 1. Carry Trade: the carry trade is when an investor sells a currency in a low interest rate county and purchases the currency in a high yielding country. This strategy is focused on capturing the spread in the interest rates, or carry, rather than making a directional bet on the exchange rate between the two. For example, borrowing at 0.25% in US dollars and investing at 7.8% in Brazilian real. 2. Trend: betting on the continuation of a price move. For example if the EURUSD is rallying, a trend following strategy would buy in anticipation of further appreciation. 3. Value: value strategies use financial methods to purchase undervalued currencies and sell overvalued ones. 1. Purchasing Power Parity 2. Interest Rate Parity 3. Balance of Payments Finance 490-402: Alternative Investments β Nov. 6, 2013
- 18. Finance 490-402: Alternative Investments Fall 2013 Currency Styles - Value 22 2. Purchasing Power Parity: this is an approach that is based on the βlaw of one priceβ which states that a Big Mac in China is worth the same as a Big Mac in the US, regardless of the exchange rate. PPP takes this a step further, compiling a basket of nearly identical goods in each market and rebases the exchange rate to set the price of this basket equal in both currencies. 3. Interest Rate Parity: essentially states that interest rate arbitrage (or carry) should not hold over the long term, and hence real interest rates (nominal rate minus inflation) will normalize across countries. 4. Balance of Payments: this approach essentially means the true value of a currency is that which balances the current account and the capital account. The current account is the sum of the balance of trade, or imports versus exports in an economy β it is the sum of currency transactions for trade flows. The capital account is the net change in ownership of foreign assets, essentially the sum of the currency transactions for investment flows. Finance 490-402: Alternative Investments β Nov. 6, 2013
- 19. Finance 490-402: Alternative Investments Fall 2013 Currency Styles 23 Deutsche Bank FX Indices Carry: Currency Harvest Index takes the G10 currencies and ranks them by 3 month LIBOR rates, going short the 3 lowest rates and long the 3 highest yielding currencies. This index is rolled and rebalanced quarterly. Trend: FX Momentum takes the G10 currencies and ranks them by their 12 month rolling return versus the dollar, going long the 3 highest returning currencies and short the three lowest returning ones. This index is rebalanced monthly. Value: FX PPP takes the G10 currencies and ranks them by the difference between their sport rate and the purchasing power parity rate as calculated by the OECD, going long the 3 most undervalued and short the 3 most overvalued currencies. This index rebalance and rolled quarterly. Finance 490-402: Alternative Investments β Nov. 6, 2013
- 20. Finance 490-402: Alternative Investments Fall 2013 Currency Styles β Deutsche Bank Currency Indices 24 Finance 490-402: Alternative Investments β Nov. 6, 2013 40% 140% 240% 340% 440% 540% 640% 01/01/94 11/01/94 09/01/95 07/01/96 05/01/97 03/01/98 01/01/99 11/01/99 09/01/00 07/01/01 05/01/02 03/01/03 01/01/04 11/01/04 09/01/05 07/01/06 05/01/07 03/01/08 01/01/09 11/01/09 09/01/10 07/01/11 05/01/12 03/01/13 G10 Carry Index FX Trend FX Value Index S&P 500
- 21. Finance 490-402: Alternative Investments Fall 2013 Currency Styles 25 Index Return Volatility Sharpe Deutsche Bank G10 Carry 5.46% 9.07% 0.436 Deutsche Bank FX Trend 4.36% 9.06% 0.315 Deutsche Bank FX Value 3.37% 8.40% 0.223 S&P 500 8.79% 15.28% 0.477 Carry is the best performing currency style index, providing the highest return of the currency styles, although less than equities. However, the volatility for all strategies is far less than that of equities and as a result, carry has a slightly superior Sharpe ratio to stocks. Finance 490-402: Alternative Investments β Nov. 6, 2013
- 22. Finance 490-402: Alternative Investments Fall 2013 Virtual Currency 26 Finance 490-402: Alternative Investments β Nov. 6, 2013 Bitcoin is a peer-to-peer digital currency that functions as a medium of exchange without the intermediation of any central bank or monetary authority. It was created in January of 2009 and consists merely of encrypted digital code to prevent theft and double spending. There are currently 11.5 million bitcoins in circulation, and production will halve every four years until a total of 21 million bitcoins are in circulation. While used extensively for illegal transactions, speculation, and hoarding (hedging against inflation), some major internet destinations such as Reddit and Baidu are now recognizing bitcoin as a legitimate medium of exchange.