Currency Trading Made Easy

By Mahjabeen Zaman

Foreign exchange: a growth market for Australia

For decades, foreign exchange was a forgotten asset class for most investors but the impact of global financial shocks has awakened appreciation of how different investments perform in changing markets.

Foreign exchange has been a clear winner. And that’s because it is driven by market perception of a country’s performance, and certainly for the past decade it has been the bellwether indicator of faith in a nation’s central bank policy. It is also prone to great volatility, so it can be difficult to navigate for the novice investor.

With trillions in currencies exchanging hands every day, foreign exchange is arguably the world’s largest and most liquid financial market. According to the 2016 Triennial Survey, trading in foreign exchange (FX) markets averaged $US5.1 trillion per day in April 2016 with the major centres being New York, London, Japan, Hong Kong and Singapore.

In Australia, the total daily average FX turnover was around $US111 billion as of October 2017 but it is growing strongly as annual growth of foreign exchange in Australia from 2012-2017 outpaced GDP at 5.7 per cent.

Several external factors have been driving this growth, including inward and outward bound travel, increase in foreign students and new migration.

The case for considering currencies

The perception of currencies as a store of value and a unique asset class has grown slowly over the past 10 years. In particular, awareness of currency markets has increased materially since the Global Financial Crisis (GFC). As a result of the GFC, markets experienced large movements in FX rates and the Australian dollar dipped to lows of around US60c in October 2008, only to rally up as high as $US1.10 three years later. It made investors take more notice of currency.

Another shift that has improved currency trading is the evolution of technology. It has enabled retail investors to trade currencies in small transactions on trading platforms with efficient execution services and competitive spreads. Citi clients making larger orders would likely use our FX desk to ensure the best rate.

For retail customers, investing in foreign currencies may allow them to gain exposure to country-specific and global macro drivers that may not be available via traditional asset classes. For example, Australian investors may consider diversifying their property portfolio overseas in countries such as the UK, US or Singapore. In order to do so, they can first take an exposure in the international currency if it is undervalued relative to the AUD and then, when appropriate use the foreign currency to invest in its home currency property. This will not only diversify the assets of the investor internationally, but also provide a potential to make gains from property value moving up as well as currency appreciation.

Foreign exchange also has low correlation to the other asset classes, which means it is a great diversification tool for those investors concentrated in domestic equities and properties. Adding low correlated asset classes can significantly improve return per unit of risk in a portfolio. Adding non correlated assets to the portfolio should offer diversification benefits and improve the risk/reward ratio. The below table shows that for a period of 2008-2018, average correlations of the DXY (USD Index) are all negatively correlated to gold, oil, US and global equities.

Another key benefit in investing in foreign exchange markets is the ability to take long and short positions - this is where investors can benefit from either a rise or fall in value of a currency.

When considering FX however, investors need to consider the range of factors that can impact FX movement. For example, exchange rate policy, inflation, terms of trade (exports & imports), growth, country risk premium, geopolitical events and other cyclical factors can all cause quick shifts in the value of a currency. As a result, investors need to be in tune to market changes/events that may affect currencies movements in order to achieve the desired diversification benefits.

An active or passive approach

Positioning FX in the portfolio can be done via both via active or passive strategies.

• An active strategy is for investors who wish to profit from fluctuations in currency over time (speculation).
• A passive strategy is a buy and hold strategy to achieve portfolio diversification.

A third way to allocate FX within the portfolio is for hedging purposes. Investors with securities in international securities may not want to take on currency risk, so they can use FX as a hedging tool to reduce the downside risk of the investments, giving them better control of their portfolio.

While there are three main currency investing strategies: carry, momentum and value investing, the main strategy used is the carry trade, although it has been less popular in a low interest rate environment.

• The carry trade is where investors take long positions in currencies backed by high interest rates and short low yielding currencies.

With central banks of some advanced economies now embarking on an expansionary monetary policy we may see a revival of the carry trade.

Carry trade can give investors an opportunity to gain exposure in the emerging market currency space; for example, buying a basket of Turkish Lira and South African Rand where interest rates are high, funded by lower yielding currencies such as Euro or the Yen. With such a strategy, investors can switch the currencies in their basket to reflect changes in interest rates.

• Momentum investing is when an investor expects an FX spot rate to appreciate further after a recent rally and to quickly sell it when it turns down.
• Value Investing focuses on buying undervalued currencies and selling overvalued currencies based on deviations in the purchasing power parities.

A considered approach

With the increasingly easy access to investing in currency markets, it indeed does deserve an allocation in the portfolio. There are many benefits of adding currency to the portfolio, such as introducing low correlation to traditional asset classes, around the clock execution, access to emerging market exposure, and lower cost of investing via e-FX platforms.

Mahjabeen is an investment specialist at Citi. An edited version of this article first appeared in Financial Standard.