The evolution of an asset class - Commerzbank - Commerzbank AG
The evolution of an asset class - Commerzbank - Commerzbank AG
The evolution of an asset class - Commerzbank - Commerzbank AG
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COMMERZBANK<br />
<strong>The</strong> <strong>evolution</strong> <strong>of</strong><br />
<strong>an</strong> <strong>asset</strong> <strong>class</strong><br />
Discussing <strong>an</strong>d defining the development <strong>of</strong> FX as <strong>an</strong><br />
<strong>asset</strong> <strong>class</strong> – <strong>an</strong>d what this me<strong>an</strong>s for investors.<br />
Jessica James<br />
HEAd Of tHE QuANtitAtivE<br />
SOlutiONS GROup
pERSpECtivES COMMERZBANK<br />
“It took over a century for<br />
the equity <strong>asset</strong> <strong>class</strong><br />
to evolve into the liquidly<br />
traded indices we see<br />
today. FX has m<strong>an</strong>aged<br />
it in a decade.”<br />
We all know what <strong>an</strong> <strong>asset</strong> is. It is <strong>an</strong> equity, or a<br />
bond, or a commodity. Perhaps it falls into the<br />
‘alternatives’ bracket, like real estate or beautiful<br />
paintings. But FX? How c<strong>an</strong> the exch<strong>an</strong>ge rate<br />
between two currencies be called <strong>an</strong> <strong>asset</strong>? And<br />
yet it is now widely regarded as <strong>an</strong> <strong>asset</strong> <strong>class</strong> in<br />
its own right. All <strong>of</strong> our pension schemes are likely<br />
to have a few percent allocated to the FX <strong>asset</strong><br />
<strong>class</strong>; by m<strong>an</strong>y measures, it performed better th<strong>an</strong><br />
equities during the 2008 crisis. How did a set <strong>of</strong><br />
exch<strong>an</strong>ge rates turn into <strong>an</strong> investment?<br />
<strong>evolution</strong> oF FX as <strong>an</strong> <strong>asset</strong> <strong>class</strong><br />
Let’s consider the history <strong>of</strong> FX. While interest<br />
rates were recorded in <strong>an</strong>cient Egypt, <strong>an</strong>d credit<br />
derivatives were used to fin<strong>an</strong>ce 14th century<br />
trading ships, the first time that FX rates were<br />
freely floating instruments was in the post-<br />
Bretton-Woods era, after the 1970s.<br />
Global FX turnover<br />
USD trillion<br />
4.5<br />
4<br />
3.5<br />
3<br />
2.5<br />
2<br />
1.5<br />
1<br />
0.5<br />
0<br />
1989 1992 1995 1998 2001 2004 2007 2010<br />
Source: B<strong>an</strong>k <strong>of</strong> international Settlements, June 2012<br />
This new market rate was controversial. How<br />
would it evolve? Initially it was assumed that it<br />
would be determined either by interest rates <strong>an</strong>d<br />
inflation (higher yielding countries would have<br />
weaker FX rates) or by the prices <strong>of</strong> similar<br />
baskets <strong>of</strong> goods in different countries (they<br />
should cost the same after currency conversion).<br />
But it soon became clear that while volatile <strong>an</strong>d<br />
individual, FX rates displayed patterns which<br />
allowed the savvy trader to make money – <strong>an</strong>d the<br />
era <strong>of</strong> currency trading for pr<strong>of</strong>it could begin.<br />
In the 1980s, currency traders discovered trends.<br />
Trending behaviour occurs when <strong>an</strong> FX rate moves<br />
in the same direction for some time, possibly due<br />
to long-term economic divergencies between<br />
economic regions. It was a gift to traders –<br />
forecasting became easy. As the decade<br />
progressed, the FX carry trade also became<br />
popular. This took adv<strong>an</strong>tage <strong>of</strong> the fact that FX<br />
rates did not usually move to c<strong>an</strong>cel out the<br />
potential pr<strong>of</strong>it which could be made by<br />
borrowing in a low yield currency to invest in a<br />
higher yielding one. Doing this trade allowed the<br />
trader to accumulate steady pr<strong>of</strong>its over time.<br />
How to invest in FX<br />
In the 1990s, dem<strong>an</strong>d rose for structures which<br />
would open up the FX world to the investment<br />
community. Essentially, capital needs to be<br />
supplied to cover the various risks associated<br />
with <strong>an</strong> FX trading strategy (drawdown, credit,<br />
etc) <strong>an</strong>d is then held in <strong>an</strong> account which buffers<br />
a set <strong>of</strong> trades. This principle has been used to<br />
create swaps, notes, funds, m<strong>an</strong>aged accounts,<br />
hybrid <strong>an</strong>d option structures, <strong>an</strong>d m<strong>an</strong>y more<br />
deal types, all <strong>of</strong> which derive from the same<br />
underlying principle – to allow investors to<br />
benefit from the predictability <strong>of</strong> exch<strong>an</strong>ge<br />
rate movements.<br />
it’s a massive market<br />
<strong>The</strong> <strong>an</strong>nual turnover in FX is measured every<br />
three years by the B<strong>an</strong>k <strong>of</strong> International<br />
Settlements. In the chart we c<strong>an</strong> see how the<br />
market has rocketed to prominence, unchecked<br />
by global crises. <strong>The</strong> axis is in trillions <strong>of</strong> USD.<br />
wHat Do we see toDay?<br />
While the popularity <strong>of</strong> FX as <strong>an</strong> <strong>asset</strong> <strong>class</strong><br />
continues, the focus has ch<strong>an</strong>ged. Disillusioned<br />
investors are rejecting highly complex strategies<br />
which are vulnerable to ch<strong>an</strong>ges in the global risk<br />
environment. <strong>The</strong>se days it is more popular to<br />
invest in thematic strategies which give exposure<br />
to a region, like Asia, while fully exploiting the<br />
liquidity <strong>an</strong>d low trading costs <strong>of</strong> the FX world.<br />
FX vs traDitional <strong>asset</strong> <strong>class</strong>es<br />
It’s clear from our discussion that the value <strong>of</strong> <strong>an</strong><br />
FX investment is not found in the underlying<br />
rates themselves, but rather in the rules used to<br />
trade them. This is less unfamiliar th<strong>an</strong> it may<br />
seem. An equity index like the DAX ® has rules for<br />
entry <strong>an</strong>d exit; in effect it is a trend-following<br />
strategy: comp<strong>an</strong>ies enter as they gain in value<br />
<strong>an</strong>d exit as they fall in value. What is different<br />
about FX is the speed <strong>of</strong> development <strong>of</strong> the<br />
market. It took over a century for the equity <strong>asset</strong><br />
<strong>class</strong> to evolve into the liquidly traded indices we<br />
see today. FX has m<strong>an</strong>aged it in a decade. <strong>The</strong><br />
future will be interesting. JJ
PersPectives<br />
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