This year’s most profitable foreign-exchange trade is signaling increased optimism that the first global recession since World War II is easing.
Bets that currency swings will continue falling from record highs produced profits in each of the past five months for a 32 per cent gain, the best performance for that length of time, according to ABN Amro indexes. The strategy was the only one of four currency tactics simulated by ABN that made money in the first quarter.
Currency fluctuations ebbed as global economies recovered from the turmoil that followed Russia’s 1998 default and the September 11, 2001, terrorist strikes. Now, the JPMorgan Chase & Co. benchmark index of investor expectations for currency swings, known as implied volatility, has fallen to 14.4 per cent from its 27 per cent October record. The G7 Volatility Index’s decline since mid-January is the steepest three-month drop since its 1992 inception.
“Big currency moves are behind us,” said Maxime Tessier, chief of foreign exchange at Montreal-based Caisse de Depot et Placement du Quebec, Canada’s biggest pension fund manager, with C$120 billion ($98.6 billion) in assets. “The volatility spike has to unwind itself over time. Selling volatility has been the winning trade so far this year and will continue to work well.”
Past experience
That may be good news for the global economy. Within a week of the 9/11 attacks, the JPMorgan index jumped to 13 per cent from 11 per cent. By April 2002, that gauge of expectations for US dollar swings over the coming three months versus the yen, euro, pound, Swiss franc, Australian dollar and Canadian dollar had fallen to 8 per cent as the US recovered from a recession.
After Russia defaulted on $40 billion of debt in August 1998 during the Asian financial crisis, the index surged to almost 19 per cent in October, from 10 per cent in May. It had fallen by half when the global economy emerged from the meltdown the next summer.
Today, investors are becoming more convinced that unprecedented sums pledged by the world’s major economies, including $12.8 trillion from the US, will stem the worst financial crisis since the Great Depression. The US economy will grow 0.3 per cent in the third quarter, from a year earlier, according to the median forecast in a Bloomberg survey of 59 analysts. It probably contracted 5 per cent in the first quarter and will shrink 2 per cent in the second, the survey shows.
“FX vol tends to be correlated with the business cycle, and normally peaks after troughs in growth,” Goldman Sachs Group strategists led by London-based Thomas Stolper wrote to clients on April 8. “That appears to be a good description of the current situation.”
JPMorgan’s index remains elevated relative to historic levels, signaling continued demand for protection. The index, which usually moves in tandem with actual fluctuations, remains above 14 per cent, a level it has breached only seven times at closing since its mid-1992 creation.
Expectations for swings in the US dollar versus the Canadian dollar over the next two years are about 15 per cent, compared with 14 per cent for the next two months, suggesting investors see currency volatility remaining elevated.
“Although volatility levels have peaked, they are still pricing in significant market uncertainty in the years ahead,” said Geoffrey Yu, a London-based foreign-exchange strategist at UBS, the world’s second-biggest currency trader. “So long as the banking system is still under stress, people will want protection. We are far from giving banks a clean bill of health, which means there will be more nasty shocks along the way.”
$4 trillion in losses
Since the start of 2007, the world’s largest financial companies have reported loan-related writedowns and losses of $1.3 trillion, about the size of Russia’s economy. Global losses may total $4 trillion, the International Monetary Fund will announce on April 20, according to an April 8 report in the Financial Times.
RBS Securities takes a different view. In an April 15 note to clients, it said exchange rates for the euro, yen and the dollar suggest there is little room for extreme swings because they are closer to their 10-year averages than any time since 1997.
Volatility expectations on three-month euro-dollar options fell to 14.15 percent today from 25.39 per cent in December, the highest level since Bloomberg started compiling that data in 1998. Tessier predicted it will decline to about 11 per cent.
“People are still willing to pay a premium for insurance against disaster, which is keeping implied volatility from falling too much,” said London-based Henrik Pedersen, chief investment officer at Pareto Investment Management. “That is probably why there is value in doing the opposite” by selling options, said Pedersen, whose firm oversees more than $46 billion. Traders use implied volatility to set options prices.
Goldman Sachs’ April 8 analysis concluded that actual volatility on one-year euro-dollar options, which stood at 15.7 per cent on April 14, is higher than the bank’s economic model suggests it should be by 4.7 points. The deviation was the most since the mid-1970s, Goldman Sachs said.
Lower volatility typically follows the easing of monetary policy by 18 to 24 months, said Alan Ruskin, head of international currency strategy in North America at RBS in Greenwich, Connecticut, in an April 15 research note. The Federal Reserve lowered interest rates to a range of zero to 0.25 per cent from 5.25 per cent 19 months ago, in September 2007, in an attempt to stave off the recession as the housing market collapsed.
“I would expect volatility to continue to drop,” said Andrew Milligan, the global strategy chief at Standard Life Investments, which oversees $181 billion in Edinburgh. “We are still expecting to see a lot of policy statements reassuring investors that the governments are in charge, and we will see an upturn in economic activities.”
A so-called short volatility strategy, where investors sell options that protect buyers against currency swings, gained 32 percent from Nov. 1 through March 31, ABN’s Volatility Capture Style Index shows. That’s its best five-month performance since the index’s 1974 start and among the top dozen gains for that length of time in any of ABN’s four currency-trade gauges. The volatility strategy had lost a record 29 percent in October. Its 12.8 percent drop last year followed smaller drops from 2005 to 2007 -- its first multiyear losing streak.
Straddles, strangles
Investors typically short volatility by simultaneously selling the right to buy and to sell a currency at set strike prices, known as call and put options. When volatility expectations fall, so does the price of that protection, and the seller makes money. Such strategies can use identical strike prices, known as straddles, or different ones, strangles, with the former being riskier.
An investor who on January 2 sold $10 million worth of three- month euro-dollar option strangles with a call price of $1.5135 and a put price of $1.2921 would have reaped a $338,000 profit at the end of the first quarter as implied volatility fell to about 18 per cent from about 23 per cent, Bloomberg data show.
Momtchil Pojarliev, currency chief at Hermes Pension Management in London, said he has been selling volatility since October, mainly with short strangles, which he considers “definitely the winning bet.” One of his positions is on the Canadian dollar versus the US currency. Pajarliev, whose company oversees about $39 billion, predicted one-year implied volatility on the pair will drop 3 points to about 12 per cent.
Carry trade
Smaller fluctuations benefit another common currency strategy, the carry trade, where funds borrowed from countries with lower interest costs are invested in those with higher rates, allowing investors to pocket the difference. Low volatility decreases the chance that sudden moves will wipe out carry trade profits.
An increase in carry trades would boost currencies from higher-interest rate nations, such as the Australian dollar, and hurt legal tender from economies with lower rates, including the yen. Over the past two months, the dollar in Australia, where the central bank benchmark rate is 3 per cent, has gained 16 per cent to 69.46 yen in Japan, where the corresponding rate is 0.1 per cent.
The Aussie lost 35 per cent against the yen last year, when three-month volatility expectations on the pair more than tripled to a record 54 per cent between January and October. It is now 27 per cent.
In vogue
Selling option volatility was in vogue after the 2001 recession ended until mid-2007. During that period, increased transparency by central banks and stable interest rates damped currency swings. The ABN volatility-strategy index’s best year was 2004, when it gained 26 per cent.
JPMorgan’s volatility index for emerging markets rose to a record 35.8 per cent in October, from about 10 per cent in August, as currencies from Brazil’s real to Iceland’s krona weakened.
The volatility and currency depreciation caused Taesan LCD, which makes computer screen lights in Pyeongtaek, South Korea, to collapse in September as its currency derivative bets went awry. Gruma SAB, Mexico’s largest maker of corn flour for tortillas, reported a 11.1 billion peso ($844 million) loss in the fourth-quarter, in part from bad currency wagers.
“People got burned badly last year,” said Pojarliev of Hermes Pension Management. Now, “fear is disappearing. We are moving towards a normal environment,” he said. “We could see more normal levels in volatility.”
