Archive for November, 2009
Forex Fundamental Analysis Forecast for the Euro, November 25th 2009
The Outside the Box Trading Report for 25 November 2009 features currency analysis for the EUR/USD currency pair. Kris Matthews covers the bullish and bearish factors for this pair and weighs the possible outcomes.
This short video is intended to be a guide to help currency investors and traders select either a buying or selling bias for their positions.
Central Bank Exit Strategies and Timing
We have seen the first moves by central banks, notably RBA, having raised rates twice, and Norway as well. Let’s look at some of the major banks, their guiding principles and possibilities for rate increases in the next 6 months, in order of increasing strength…
The BoJ has kept rates at 0.1% since December, and the market expects no rate changes through 2010. In fact, Prime Minister Yukio Hatoyama may want stronger monetary stimulus to buttress the economy’s “recovery”. His Finance Minister said there’s a “sense of crisis” over deflation and the Deputy Prime Minister urged the central bank to take action to overcome the price slump by stepping up purchases of JGBs (already at $20B/month). So not only no exit, but a potential stepping up of QE!
The Federal Reserve’s Bullard states emphatically that the Fed won’t be raising rates until 2012. The Fed has a dual mandate for growth and inflation targeting, and I believe it will remain accommodative for a long time to come. The market expects most other banks to be far faster in their rate increases, and is looking for the Fed to raise rates by only 125 bps for the one year forward.
The BoE is tasked with price stability. Given the growth for 2010 is forecast at 1.9%, the market is expecting BoE to be one of the first to tighten in 2010 according to futures. On the other hand, the OECD said the BoE should keep its rates low until 2011. In the latest BoE minutes, the board was split on increases vs more QE. Currently at 0.5%, maybe expect 1.25% in 2010
The ECB is showing some signs of impatience to unwind its emergency steps, recently announcing plans to tighten terms on which it lends liquidity to banks. Trichet sees further exit delays creating asset bubble risks and excess bank profits (bank source of funds at zero). The ECB is a strict inflation targeter, with rates currently at 1%. There will be some tightening by stealth (bringing market closer to target rates). The market is projecting 1.75% over one year.
The Norges Bank, the first in Europe to increase rates (by 0.25% to 1.5% last month), has a mandate of maintaining price growth (CPI) of close to 2.5%. However, inflation has exceeded the bank’s target in six of nine months this year, so they need to be even more aggressive! Yet as an exporter, they must remain fearful of a too-strong Krone. So I expect the Norges Bank to move deliberately (as they all do), and increase rates at every second meeting to 2.75 percent within 12 months.
Over in Oz, rates have gone from 3.0% to 3.25% and then 3.50%, the market is pricing in a rate hike to 5% in 2010. This makes sense from the expected growth rates (GDP +3.25% in 2010!), and the fact that the RBA is tasked with keeping the inflation rate between 1%-2%. However, the latest RBA minutes indicated a much less hawkish stance than expected, so maybe not all 150 bps will materialize in the next 6 months.
Paul Stafford contributes regularly to The Gestalt Shift and publishes an analysis report for trading the forex market based on fundamentals, the “Stafford Weekly Currency Briefing,” on 4xtradertools.com
Trading Psychology- Emotion Free Forex Trading Training
Successful trading is 20% mechanics and 80% psychology. I’ve created this video to help you understand what negative psychology is holding you back from successful trading and train yourself to trade forex profitably and without emotions. This is basically everything that I’ve gathered from my own experiences, from modeling after star traders from banks and hedge funds, and from trading psychology experts like Van Tharp.
Forex Fundamental Analysis Forecast for the Yen, November 17th, 2009
A concise forecast of the currency market using forex fundamental analysis and strategy. This video covers what’s been happening in the Yen, how to weigh the outcomes, and what to expect so that you can develop an effective strategy and choose the right direction.
Forex Fundamental Analysis Forecast for the Euro, November 2009
Outside the Box Trading Report by TradeForexFundamentally.com
The Outside the Box Trading Report for 11 November 2009 features currency analysis for the EUR/USD currency pair. Kris Matthews covers the bullish and bearish factors for this pair and weighs the possible outcomes. Kris also considers factors that could come into play that could influence the direction of the Pound.
This short video is intended to be a guide to help currency investors and traders select either a buying or selling bias for their positions.
Paul Stafford on “The Carry Trade”
With a second increase in the RBA (AUD) central bank rate to 3.5% and the Norges bank (NOK) also recently increasing its rate by 25 bps (target rate 1.25-2.25%), the carry trade may be resurrected from the ashes of 2008. The carry trade unwound completely this year as central banks reduced their rates (eg the RBNZ dropped rates from 7.25% to 2.5%) in order to re-flate the world economy. Now I believe we are poised to see many countries’ rates move upwards over the next year, while others (funding currencies) will likely remain low.
First, a review of what the carry trade is might be helpful. Carry trade is a strategy which takes advantage of the different interest rates in different countries. The difference can be dramatic, as this table shows:
|
Currency |
Rate |
|
BRL |
8.75% |
|
ZAR |
7.00% |
|
TRY |
6.75% |
|
PLN |
3.50% |
|
AUD |
3.50% |
|
INR |
3.25% |
|
NZD |
2.50% |
|
NOK |
2.25% |
|
KRW |
2.00% |
|
GBP |
0.50% |
|
CHF |
0.25% |
|
CAD |
0.25% |
|
$ |
0.25% |
|
JPY |
0.10% |
Generally, the difference in interest rates can be traced to the differences in risk of default in each country. As you can see, the Brazilian Real, the Turkish Lira and the South African Rand top the list, while the US and Japan hold down the bottom of the risk and return list. I am sure an interesting correlation could be made between the interest rate and the Sovereign Credit Default Swap rate (exercise left to the reader).
Historically, the JPY was used to fund the carry trade, but now the dollar is also a very attractive funding currency. With few signs that the US will exit its loose monetary policies any time soon, it looks likely to remain so at least through next year. One effect of carry trade is that the funding currency is weakened as it is sold to buy the higher-yielding currency, which strengthens on higher demand. This is the effect that weighed on the JPY between 1996 and 1998, and again between 2001 and 2008. Much of hedge fund returns can be traced to the carry trade. The size of the previous carry trade phase could have been as high as $1Trillion
There are several ways in which to play the carry trade. One way is to exchange one currency for another, and then invest in risk-free securities in that currency, such as bonds, which will earn more interest than in the base currency. This is a little cumbersome.
Another method is to initiate positions in the Forex market. For example, when an investor goes long the AUD/JPY, he is short a currency whose central bank pays 0.1%, and long a currency whose central bank pays 3.5%. An FX market maker will either pay out (or as appropriate, charge) a carry interest, which is what the investor is interested in. It is not usually as simple as taking the difference between the central bank rates, as the market maker adjusts daily, takes a spread, and bases the rate on indices (such as Libor) that closely track the central banks rates .
The Forex method is more common because it is easier to utilize leverage to enhance the interest rate difference. Assuming for the moment that the simple difference is what is paid, a 1:1 position in AUD/JPY would pay 3.5%-0.1% = 3.4%/annum; not an especially interesting number. However, F/X carry trade investors can utilize a higher leverage such as 10:1, which would generate a return of 34%, a very exciting number. OK, what’s the catch? It’s simple- the risk of the exchange rate moving against the investor.
For example, the BRL might be seen as an excellent choice of currency to be long. In the period from 2003 to 2007 the BRL appreciated from 4.0BRL/$ to 1.6BRL/$, a 250% rise. Not only were investors getting an enormous interest rate differential, but saw the currency appreciate as well. However, if you initiated this trade in early ’08, the BRL dropped 50% in value, more than wiping out any interest rate differential. This risk can be mitigated in several ways.
- One way is to stick with the majors. Which the rate differentials are not as high, leverage can boost returns and the exchange rates don’t exhibit extraordinary volatility.
- A second way is to buy insurance. There are option strategies (eg collars) which limit the effects of exchange rate volatility, while allowing an investor to benefit from rate differentials. The cost of the collar is minor, depending on the leverage utilized. N.B this is also the tactic major import-exporters use to insure against F/X exposure, along with forwards.
An investor thinking of initiating a carry trade should line up all the macro ducks they can- twin surpluses (ie current acct and budget), purchasing price parity vs spot, GDP growth- etc. They should also manage risk by calculating the effects of exchange rate swings on the potential position, and potentially taking out insurance. A carry trade is truly a longer-term trade, as you need to hold the position for lengthy periods to maximize the interest return. However, this also increases your exposure to the drift in the exchange rate (as opposed to just the volatility). Also, there is a small but non-zero chance of a central bank devaluing a currency (eg Mexico or one of the Central and Eastern Europe (CEE) countries).
The carry trade may very well be one of the winning strategies in the next several years. Many of the higher yielding currencies-especially in the Emerging Markets (EM)-are set to appreciate more than the funding currencies of the majors ($, CHF, JPY).
Paul Stafford writes a weekly Currency Briefing, which covers fundamentals and sentiment measures for the major currencies. If you are interested in receiving it, please visit www.4xtradertools.com
Forex Fundamental Trading Analysis for EUR USD, 11/3/09
This weekly forex fundamental analysis video covers the eur usd for profitable currency forecasting and trading
Volatility and Value at Risk
Volatility is a key concept in trading, whether you trade currencies, equities or even metals. In a nutshell, volatility is the speed of the market- how fast, and how far can an underlying move be. Volatility and its close cousin Value at Risk (VaR) are great tools for understanding and managing portfolio risk.
While there are many dangers inherent in simplifying reality, price action can be usefully described by a normal distribution. We can make use of this tool in understanding the potential for price action based on historical movements, and get a pretty good idea of Value at Risk in any position. We’ll take a nice volatile pair like AUD/JPY to illustrate, using one year’s daily price action:
Before we calculate volatility, a key concept that you should be familiar with is that of log normal returns. If I have a series of prices, I can calculate the daily change using percent. If I want to aggregate a series of price changes, though, I cannot add percents. However, if I take the natural log of the ratio of prices, I can add those numbers to aggregate the returns, because you can sum logs. Here’s a small sample of AUD/JPY, using log normal returns. The sum of the log normal returns is 17.9%, which accurately reflects the total change from 55.7 to 66.7
|
daily price |
LN (n+1/n) |
|
55.765 |
|
|
62.84 |
11.94% |
|
64.963 |
3.32% |
|
67.195 |
3.38% |
|
65.42 |
-2.68% |
|
67.01 |
2.40% |
|
69.651 |
3.87% |
|
66.701 |
-4.33% |
Now back to volatility. A normal distribution is described by its mean and its standard deviation. We will take the mean to be the starting price, and the standard deviation is easily calculated. Given a series of daily returns, say for a year, we can easily calculate the standard deviation of the series. Using the trailing year’s daily returns for AUD/JPY results in a 2% Std Dev. Since I am using daily returns, I must multiple 2% by the SQRT of the number of trading days in one year (258) to get a total yearly volatility of 32%. If instead I want to calculate the volatility for one month, I multiply 2% times the SQRT of 22 (the number of trading days in a month) to get 9.38% volatility.
Now to Value at Risk, or VaR. VaR is a risk measure, the risk of a specific loss, given a specific time horizon and confidence level. There are several approaches to modeling VaR (historical, parametric, hybrid). For simplicities sake we will use historical price action as a basis for calculating VaR. Let’s examine the distribution of daily returns, and see what percent of the time they fall below our threshold. Here’s a plot of the number of days AUD/JPY log normal returns falls into each bin (0.5% bins):
They mostly resemble a normal distribution (validating our assumption), and are distributed with a slight positive skew (after all, AUD/JPY has done quite well this year).
We can use the excel function “percentile” to easily get the daily Value at Risk to any level of confidence. For example, if we want the VaR to the 95% confidence level, we set 5% in the percentile function, and get -2.84%, which is to say that 95% of the time you won’t lose more than that in one day. The VaR at a 99% confidence level is -4.77% (ie 99% of the time you won’t lose more than 4.77% in one day). To get VaR for longer periods, simply multiply by the SQRT of the number of trading days in the interval. A 95% VaR over one month would be -13.32%.
I’d like to point out the existence of a fat tail. Note the little data point out at +12%. A year ago, AUD/JPY jumped in one day from 55.76 to 62.84. Extraordinary, and a great example of how assuming a normal Gaussian distribution can hide outliers. It is a little beyond the scope of this article to examine skew and kurtosis, other than to mention that there are other, more heavy tailed distributions (such as Cauchy) which more accurately represent the real world. When I generate Monte Carlo simulations to calculate my own VaR, I use what are called Pearson IV random deviates, which lets me create skewed and fat-tailed distributions for a more accurate idea of my VaR.
I hope that this has been of some interest and help in understanding volatility and how it impacts your portfolio.
