LCVI’s predecessor, the Liquidity and Credit Premia Index (LPCI), lacked any input for US equity market volatility. According to Mustafa Caglayan, who developed the LCVI, traders inside and outside the bank had been pushing for an equity component.
Kantor said that in the late 1990s US equity markets became an important driver in the global FX market. “Net equity inflows got to levels on the order of $150 billion a year or more,” said Kantor. “Prior to the late 1990s we’d never even seen a year at $50 billion.”
The bank has found strong evidence of the US equity market and FX relationship. Since the beginning of 2002, the trade-weighted US dollar and the Standard & Poor’s 500 stock index have had a correlation of 88 percent, according to Caglayan.
To appreciate the equity market signal, the LCVI incorporates the VIX, a measure of implied stock volatility, or risk appetite, compiled by the Chicago Board Options Exchange.
Though a fall-off in equity markets this year might suggest diminished importance for the equity component in any FX trading model, according to JP Morgan Chase analyst Rebecca Patterson, other important flows, like cross-border mergers and acquisitions, have dropped as well.
“If you go on our trading floor and ask the equity traders, or go over to fixed income trading and ask those guys if they watch the equity market – you better believe they do,” Kantor added.
According to JP Morgan Chase figures, trading the bank’s basket of G-10 currencies, the FX CACI basket, with the LCVI would have resulted in a gain of 9.33% so far this year.