What Works to Produce Sustainable Returns in Currency?

• Strategies for earning sustainable return in currency are more nuanced than in equities or bonds due to the absence of a “long-only” beta
• We argue that there are, however, strategies to target sustainable returns in the currency space
• This blog post describes growth, carry, momentum and value as potential sources of return in currency

How do investors sustainably make returns in the currency space? Clearly, this is more complicated than in equities or bonds- there is no “long-only” beta in currency. Nevertheless, there are sustainable sources of return in currency which can make returns over time, which we summarise in this blog post:

1. Growth

Economies which see faster productivity gains find their exchange rates appreciate in real terms. An investor which takes a long position in faster growing economies, funded by a short position in more slowly-growing economies, can expect to pick up this appreciation on average.

This relationship between growth and currency appreciation is referred to as the Balassa-Samuelson effect: exchange rates vary according to productivity because of the existence of a non-tradable sector. As economies become more productive, increases in productivity in the tradable goods sector lead to wage increases which filter into the non-tradable sector raising prices and wages. The resulting price rises cannot be arbitraged out by the exchange rate, and this expresses itself as a real exchange rate appreciation (see Figure 1).

This effect is particularly prominent in Emerging Market (EM) economies. Productivity growth is related to GDP per capita through the Convergence Hypothesis. This states that poorer economies grow more quickly to “catch-up” with richer economics. Consequently, EMs tend to see real appreciation against Developed Market (DM) economies. 

2. Carry

The currency carry trade takes a long position in higher interest rate currencies, funded by a short position in lower interest rate currencies. On average, currency spot movements are insufficient to cancel out the raw interest rate differential, which is the source of the returns to the carry strategy.

Why does the carry trade make money, and why are its returns not simply arbitraged out? Similar to the commodities carry trade, the currency carry returns reflect a risk premium. The reason that high interest rate economies offer high real interest rates is that they are riskier economies to lend to, and must compensate investors for this. In DM economies, countries with persistent current account deficits must find a way to fund these, and typically this funding comes at a price (see Figure 2). Norway is an outlier because its large sovereign wealth fund “sterilises” current account surpluses by keeping them offshore. In EM economies, higher real interest rates additionally reflect perceived inflation risk and policy credibility.

Hence, the currency carry trade consists in taking on the risk of lending to certain economies. Investors will not take this risk on for nothing: in return, they demand a risk premium. 

Momentum

Currency movements are not a random walk: there is information in today’s price that helps predict future price evolution. Currencies tend to “mean-revert in the very long-term or short-term but over a 3 to 12 month horizon, certain currency pairs tend to exhibit momentum or “trending”. Statistically, the existence of currency trends can be defined using “volatility bars”, which show annualised volatility calculated across different time horizons. In a data-generating process where there are no autoregressive or mean-reverting elements, the variance does not depend on the time horizon (and hence the volatility of the associated time series should be similar regardless of the horizon at which it is measured). By contrast, in a trending time series the variance increases as the time horizon increases. Intuitively, volatility at the near end of a trend should be lower than in the trend taken as a whole.

Figure 3 shows that this applies to six major currency pairs, and on average in the G10 currency universe. The USDCAD pair is an exception, (where we argue that momentum is likely rapidly arbitraged because of geographical links) as is the AUDUSD pair.

Why do currencies exhibit momentum? Firstly, information may filter through to market participants at different time horizons, so that the market reacts in a staggered fashion to new information. Secondly, herding behaviour (trend-following strategies) may themselves generate momentum in currencies, as market participants exacerbate trends by buying into them. Thirdly, delta hedging of options may lead to tending behaviour. As the price of the underlying currency rises (falls) the delta of call (put) options rises, so entities short options must increase underlying long (short) positions in order to delta hedge. This introduces structural reasons why currencies trend.

An investor who can identify and exploit these trends will find this a key potential source of return.

Value

Currencies tend to be mean-reverting at longer time horizons. Economists use the concept of a currency’s “fair value” to describe equilibrium values to which currencies return over the long-run. An investor who can correctly identify deviations from these equilibrium values and take a position reflecting convergence back to fair value will make a medium-run return. 

One simple valuation method is the well-known concept of Purchasing Power Parity (PPP) can be used. PPP is the implied exchange rate that equilibrates the price of a specified basket of goods in two countries assuming each has their own exchange rate. The theory underpinning the use of PPP as a fair value is the “law of one price”. This states that over the long term, sustained deviations from PPP cannot persist, because they would be arbitraged out (consumers would see an opportunity to purchase goods only in the cheaper currency).

There are sustained deviations from PPP due to the Balassa-Samuelson effect (see Figure 1).In the G10 universe, GDP per capita is sufficiently similar that PPP works as a valuation measure. Those wishing to trade value in the EM universe may need a more complex valuation methodology. 

Naturally, optimal currency investing requires a sensible combination of these strategies, as well as nuanced implementation and effective risk management. While not exhaustive, however, these strategies provide a basis for how investors can think intelligently about how to target returns in the currency space.

Assumptions and Risk Warnings
This material has been produced for professional investors. Certain assumptions around your knowledge of market practices, derivative instruments, and the associated risks are assumed as understood. The views about the methodology, investment strategy and its benefits are those held by Record Currency Management Limited at the time of presentation. All data, unless otherwise stated in the footnote of the relevant page is as at 7^th February 2017 and may have changed since.
Issued in the UK by Record Currency Management Limited. This material is provided for informational purposes only and is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities, Record Currency Management Ltd products or investment services.
There is no guarantee that any of the strategies and techniques will lead to superior investment performance. All beliefs based on statistical observation must be viewed in the context that past performance is no guide to the future. There is no guarantee that the manager will be able to meet return objectives and tracking error targets. Changes in rates of exchange between currencies will cause the value of investments to decrease or increase.  Before making a decision to invest, you should satisfy yourself that the product is suitable for you by your own assessment or by seeking professional advice. Your individual facts and circumstances have not been taken into consideration in the production of this document.

Regulated status
Record is authorised and regulated by the Financial Conduct Authority, a registered investment adviser with the Securities and Exchange Commission in the US, and registered as a Commodity Trading Adviser (swaps only) with the US Commodity Futures Trading Commission, is an Exempt International Adviser with the Ontario & Alberta  Securities Commissions in Canada and is registered as exempt with the Australian Securities & Investment Commission.

Performance warnings
Past performance is not a guarantee of future results. Portfolio returns are gross of fees and assume the reinvestment of all returns. The investment return and principal value of an investment will fluctuate so that when realised, may be worth more or less than the original investment.

Currency for Return
Any increase of the gearing ratio will lead to greater volatility of the investment and potentially greater losses. Investors with significant leverage must be aware of the risk involved in the investment proposed, including the risk of total loss of the sum invested.

Multi-Strategy
The Multi-Strategy product involves passive allocation to strategies during which positions are bought and held. Exposure is maintained to the selections between the periodic rebalancing dates and is not altered due to market factors. The Multi-Strategy product is made up of an allocation to a number of the underlying strategies which may also be invested on a standalone basis.

FRB10 Strategy
The FRB10 product often will have high levels of exposure, up to 40% of the total commitment (long or short position), to a single currency therefore investors must be aware that significant losses may be realised in a short period of time due to sudden changes in relative currency values. Changes in rates of exchange between currencies will cause the value of investments to decrease or increase. There is no systematic risk management process given the tracker nature of the product which therefore exposes the investor to potentially greater losses.

Emerging Market Strategy
Emerging Market currencies are typically subject to greater country-specific risks than developed market currencies. As a result of this and other factors, Emerging Market currency pairs are typically more volatile than developed market currency pairs. In addition, many (although not all) Emerging Market currencies are invested in through Non-Deliverable Forwards (NDFs), which are cash settled, and the pricing of which is less deterministic than for deliverable forwards. Investment in Emerging Markets tends to be more volatile than more mature markets and the value of your investments could in some circumstances move sharply either up or down. In some circumstances currencies may become illiquid which may constrain the investment manager’s ability to realise the investment. Political risks and adverse economic circumstances are more likely to arise putting the value of your investment at risk.

Momentum Strategy
The strategy involves long & short positions and trading decisions are made on the last business day of each month. Any trade direction is maintained until the following trade decision date. In the interest of trading efficiency, positions will be netted either within the strategy or across other strategies while still preserving the net economic effect of this strategy before netting.

Value Strategy
The Strategy involves long & short positions and trading decisions are made on the last business day of each month. Any trade direction is maintained until the following trade decision date. In the interest of trading efficiency, positions will be netted either within the strategy or across other strategies while still preserving the net economic effect of this Strategy before netting.