Forex Blog

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Passive Currency Investing Rises in Popularity Posted: 09 Oct 2010 07:53 AM PDT Those who read the most recent Bank of International Settlements (BIS) Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity know that daily forex turnover rose 20% over the last three years, to $4 Trillion. According to the official data, the vast majority of participants are financial institutions and the like, which would give the impression that overwhelming majority of trading is engaged in for speculative purposes. Anecdotal research, however, suggests that behind the scenes, it is “passive” foreign exchange trading that is making its presence known. “According to Deutsche Bank, ‘passive’ players – such as corporate treasurers who are looking to hedge currency risk or to facilitate their core business, not to make a profit – account for more than 50 per cent of currency flows.” By definition, these passive players are not out to make a profit, and exchange currencies only because it is necessary to simply conduct business. This is not surprising since the number of confirmed exporters in the US rose 10% during the last year for which data is available. It is almost a given that the number of exporters in emerging markets is increasing an an even faster clip. As a result, corporate banking departments are fighting to keep up with demand for currency exchange/hedging by such businesses, which simply want the ability to know their own profit margins in advance, and can set prices accordingly. Big corporations are among the most reliable hedgers: “Companies lifted the amount of estimated 12-month forward earnings hedged to 34.3 percent on average in September…boosted by a 22 percentage point rise in the U.S. corporations' hedge ratio to 55.7 percent, the highest on record.” Even Sovereign Wealth funds are reportedly interested in hedging their forex reserves. If not for the enormous pool of passive participation in forex, it might be difficult for speculators to turn a profit. ” ‘The flows from passive players have only limited direct sensitivity to broader market and macro factors, so they can serve as counterparts to investment theme-driven flows,’ ” reports the Financial Times. Since these participants are disinterested in actual forex fluctuations – so long as they can lock in exchange rates using spot and futures transactions – it creates passive momentum for currency movement, and hence opportunities for speculators (including retail forex traders) to turn a profit. In some ways, this is a free lunch to speculators. On the one hand, double-digit currency moves have become so common over the last few years as to become almost mundane, with some currencies routinely rising or falling by more than 5% a month. On the other hand, forex volatility has fallen over time (except during the financial crisis) and is lower compared to other asset classes. For example, “Annualised average daily volatility of the euro/dollar pair over the past decade, for example, is 140 per cent lower than the volatility in the EuroStoxx 50 over the same period.” In addition, “JPMorgan's index of implied volatility on options for Group of Seven currencies dropped 13 percent in the third quarter, after jumping 22 percent in the prior three months.” This is amazing, since it implies that as uncertainty has risen, risk (aka volatility) has fallen. Interest in forex is also rising among indirect investors, such as pension funds, mutual funds, and retail investors that seek exposure to currency through investment products. “In July, RBC Capital Markets published a survey of 102 asset managers…which revealed that 38 per cent say currency tops the list of asset classes they are most likely to move into over the next 12 months, ahead of equities and commodities.” On a related note, most investment advisers recommend that currencies should comprise 2-7% of every investment portfolio, regardless of objective and tolerance to risk. The number of forex investment “specialists” and related investment products appear to be rising to meet demand variously based on carry, momentum and value strategies. At this rate, it looks like forex volume will set a fresh record in 2013, when the next round of data is released.

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