Participation levels in foreign exchange have declined during the past year due to a contraction of the hedge fund industry and exit of many currency day traders. But hedging activity is picking up as businesses and investors protect themselves from volatile currency moves. And forex is increasingly being used as a liquid market to express macro views, as well as becoming an asset class in its own right. Hardeep Dhillon reports Increased volatility and diminished risk appetite in global markets have resulted in trading to be in much smaller notional sizes this year. Meanwhile, the process of unwinding complex structures and the deleveraging of positions that has kept trading desks busy during the first months of the year is steadily declining over time. But, interest in foreign exchange is nonetheless continuing to blossom in Asia and healthy investment flows are expected to continue, with bankers noting increasing activity particularly among companies and large financial institutions. That is because foreign exchange is attracting greater interest as a hedging tool - and not just to companies. Forex trading strategies this year will likely feature the strategic management of currency risk as part of portfolio risk management and implementing macro views. A strategic shift in asset allocation towards foreign exchange has also taken place due to the relative illiquidity and relatively poor performance of other asset classes, such as credit and equities. Many participants have flocked to forex because of the lure of good returns and the fact it is a liquid asset class. The financial community has learnt the importance of valuing liquidity and it is all too aware of the costs and risks involved in trying to unwind illiquid and complex positions in deteriorating markets. Now investment objectives centre on flexible and straightforward structures that are easy to exit, even in choppy markets. Despite the market trading at wide ranges and with periodic momentum moves, there are still many opportunities to capture, says Adrian McGowan, Barclays Capital's Singapore-based head of foreign exchange trading for Asia Pacific. He adds that views are not held for a long time in very volatile markets, which means that trading volatility itself becomes a trade. "We are seeing our leverage community becoming more nimble, having smaller position sizes but changing their direction much more frequently than we used to see," he says. A greater number of investors are also using foreign exchange as the best instrument to express their macro views of the market and as a proxy hedge for assets on their books. "More leveraged investors, which historically tended to invest in less liquid assets or those that had not expressed macro views through forex before, are investing in G10 currencies," McGowan says. "G10 foreign exchange is a very liquid instrument and liquidity is important as clients need something they can easily trade in and out." Mirza Baig, a foreign exchange strategist covering Asia at Deutsche Bank in Singapore, also says there is a broader interest from investors that have traditionally focused on other asset classes that are looking to invest in currencies. Previously, equity investors, fixed income and currency participants have tended to favour a relatively siloed approach to investing. Now, more equity investors in emerging markets are starting to take a more macro look at their markets and use foreign exchange as a hedging tool or to implement strategies. "We are seeing growth of a new type of investor class that is taking a more holistic view of the overall equity, currencies and bond markets and expressing views through whichever instrument they see as being the more efficient," says Baig. That is because it is more critical that institutions holding offshore asset exposures, closely manage the currency risk on their investments and monitor hedging activities, adds Udi Epstein, a director in foreign exchange structuring at Deutsche Bank in Singapore. Local institutions need to be mindful that volatile currency movements, combined with volatile movements in asset prices, can have major ramifications on the integrity and cost of currency hedging activities. "Institutions need to look a little deeper than set-and-forget passive currency hedging in an era where the euro/Japanese yen can trade in a 12% range in a single day (24 October, 2008) and the MSCI World Index can fall 35% in six weeks (Q4, 2008)", he adds. Barclays Capital's McGowan believes forex demand will remain strong as clients look to diversify their investments, and having access to liquid strategies and underlyings will be an important driver of the market. Barclays Capital's investable foreign exchange indexes have seen increasing investor demand, in particular, using G10 forex as a liquidity point to hedge against other assets on their books or express macro views. "We are looking to make foreign exchange a simpler instrument to invest in via our suite of investable indexes, which are an easy entry point for any investor whatever the level of sophistication. We are a one-stop shop offering investors very deep 24-hour liquidity in vanilla products," he says. Alpha generation Generating alpha with low correlation is leading more investors to turn towards active forex managers, which Deutsche Bank's Epstein believes represents a true de-correlated asset class compared with 'traditional' investments in equities and bonds. "More investors are looking to the foreign exchange markets to gain exposure to currency returns and generate alpha. They want to be better compensated for their currency risk as opposed to simply incurring unrewarded currency risk, and active forex alpha can help achieve this goal," he adds. The firm's FXSelect platform has an investable universe of 70 currency managers and 10 global macro/commodity trading adviser (CTA) managers. It allows investors to tailor simple solutions according to their target risk and excess return objectives. Epstein explains there is a variety of trading styles among the managers on the platform and this variety gives rise to low correlations between the managers' returns. "It is a flexible platform that provides investors access to portable alpha from a diversified group of forex and CTA managers. Increasing the number of sources of alpha reduces the overall volatility, increasing risk-adjusted returns over single sources of forex alpha," he says. Citi has also underlined its focus on providing clients with innovative products in the forex market with its April launch of CitiFX Velocity, a global foreign exchange e-commerce platform, in Asia-Pacific. Aimed at professional forex traders, the platform is to allow clients customise orders and execution needs, as well as providing them with access to liquidity offered by Citi's forex price stream. "It (CitiFX Velocity) also underlines our continued commitment to our clients across Asia-Pacific to invest in the technology and infrastructure to meet their evolving needs in the foreign exchange markets," says Lung Nien-Lee, co-head of corporate sales and structuring for Citi in Asia Pacific and Global markets head for Singapore. CitiFX Velocity offers both exchange-based and one-click streaming execution, alongside advanced-order capabilities and also supports an array of different technology vendors, allowing for easy straight-through processing. The platform will be available to clients globally, including Asia-Pacific, and covers spot, forwards and options. Since the global credit crisis and liquidity crunch, volatility has created an uncertain market environment and spotting trends or undertaking directional strategies have become a much harder task. Bertrand Lavigne, BNP Paribas' Singapore-based head of interest rates and foreign exchange trading for Asia in Singapore, believes that strategies are being built around a starkly bullish or bearish view of the global economy. "We are at a crossroads in the market because, as investment returns, we are seeing radically opposing strategies. One is positioning for a rebound in confidence after fiscal stimulus, the other a 1930s depression scenario," he says. The difficulty in spotting trends in Asian foreign exchange markets will cause many participants to rethink their trading strategies and to start focusing on factors other than simply growth dynamics or projections, says Deutsche Bank's Baig. He recommends dividing the region into two camps. One includes countries sensitive to the financial sector and more dependent on access to credit markets, such as India, Indonesia and South Korea. This group of currencies will likely strengthen with a re-opening of the credit markets or improvement in financials and weaken if financials continue to underperform and credit markets struggle. The second group includes countries that are sensitive to the underlying economic growth cycle, specifically Singapore, Taiwan and, to a lesser extent, Malaysia and Thailand. "The export dependence of these economies typically sees gross domestic product (GDP) decline by a larger magnitude compared to falls in US GDP, which can in turn place downward pressure on these currencies," he says. Baig believes the region's financial sector will stabilise well ahead of any recovery in the economic cycle of Asian countries. To play this distinction, he recommends taking a long position in a basket of credit-sensitive currencies, such as India, Indonesia and South Korea, and a short position in growth-sensitive currencies, such as Singapore and Taiwan. Asian currency gains in the past few months may also prove to be short-lived, says Brian Jackson, senior strategist in emerging markets research at RBC Capital Markets in Hong Kong. "Asian currencies have strengthened broadly in tandem with the US equity market, but we suspect that this rally will be reversed in coming months as investor concerns about emerging markets intensify," he says. To implement this view, he recommends a long position in the US dollar against the Singapore dollar, targeting a move to S$1.62 by the middle of the year from its March level of S$1.51. Jackson is mindful that the global crisis is still far from over and warns of further bad news before the market hits rock bottom, with developments in Central and Eastern Europe particularly worrying. He believes the main driver for Asian foreign exchange markets is likely to be broader global developments, including the success of stimulus packages and the performance of equity markets. "Tracking the S&P 500 will probably give you a pretty good understanding of how the forex market is going to perform in Asia," he says. The Korean won has been the weakest currency in the region but there is a belief that this may have been overdone. Bertrand Lavigne at BNP Paribas believes the won had been relatively oversold compared to the fundamentals of the Korean economy. "If the global economy improves, Korea will outperform the rest of Asia, much in the same way it underperformed (the region) during the downturn," he says. "That is the direct consequence of Korea's more open and deregulated forex market." China's strong involvement in the global economy and its capacity to rebound could have a great influence on the rest of the world, and in Asia in particular. Deutsche Bank's Baig adds that China's explicit policy of keeping its exchange rate stable has acted as a form of stability to the region's currency markets overall. Nonetheless, if China starts to devalue then devaluation elsewhere in Asia could occur. One big development in the next 12 months is how China will manage its currency reserves, states RBC Capital Markets' Jackson. He expects China's exports to remain weak given the state of the world economy, but says the government's fiscal stimulus should boost imports, resulting in some reduction in the Chinese trade surplus. This, in turn, would likely result in smaller increases in China's foreign exchange reserves and in less need for China to accumulate US financial assets. "The US is concerned about what implications this could have on the financing of their own deficit and fiscal packages," he adds. "A decrease in China's purchases of Treasuries means that the US will need to rely to a greater extent on domestic financing of its deficits."...
Start a FREE trial or subscribe to continue reading:
Start a 4 week free trial
Try Risk.net's premium content for a limited period. Register now for your FREE trial to one of our leading brands.
*not available to previous trialists or subscribers.
Log In or Subscribe Now
Subscribe to Risk.net Business now to access all our premium news & features content for 1 year.
Pay by Credit Card for immediate access.