Currency Strategy

1 Fundamental Analysis: The Strengths and Weaknesses of Traditional

Exchange Rate Models 17

1.1 Purchasing Power Parity 17

1.1.1 Reasons for “Misalignments” 19

1.1.2 Tradable and Non-Tradable Goods 20

1.1.3 PPP and Corporate Pricing Strategy 20

Example 1 20

Example 2 22

1.1.4 PPP and the Real Exchange Rate 24

1.2 The Monetary Approach 25

1.2.1 Mundell–Fleming 27

1.2.2 Theory vs. Practice 29

1.2.3 A Multi-Polar rather than a Bi-Polar Investment World 30

1.2.4 Two Legs but not Three 30

1.2.5 Implications for EU Accession Candidates 31

1.3 The Interest Rate Approach 31

1.3.1 Real Interest Rate Differentials and Exchange Rates 33

1.4 The Balance of Payments Approach 34

1.4.1 A Fixed Exchange Rate Regime 35

1.4.2 A Floating Exchange Rate Regime 36

1.4.3 The External Balance and the Real Exchange Rate 37

1.4.4 REER and FEER 38

1.4.5 Terms of Trade 39

1.4.6 Productivity 39

1.5 The Portfolio Balance Approach 41

Example 42

1.6 Summary 43

2 Currency Economics: A More Focused Framework 47

2.1 Currencies are Different 48

2.1.1 (In)Efficient Markets 48

2.1.2 Speculation and Exchange Rates: Cause, Effect and the Cycle 49

Example 50

2.1.3 Risk Appetite Indicators and Exchange Rates 53

2.2 Currency Economics 57

2.2.1 The Standard Accounting Identity for Economic Adjustment 58

Example 1 59

Example 2 60

2.2.2 The J-Curve 62

Example 62

2.2.3 The Real Effective Exchange Rate 63

2.3 Summary 63

3 Flow: Tracking the Animal Spirits 65

3.1 Some Examples of Flow models 69

3.1.1 Short-Term Flow Models 70

3.1.2 Medium-Term Flow Models 77

3.1.3 Option Flow/Sentiment Models 82

3.2 Speculative and Non-Speculative Flows 83

3.3 Summary 84

4 Technical Analysis: The Art of Charting 85

4.1 Origins and Basic Concepts 85

4.2 The Challenge of Technical Analysis 86

4.3 The Art of Charting 87

4.3.1 Currency Order Dynamics and Technical Levels 87

4.3.2 The Study of Trends 90

4.3.3 Psychological Levels 90

4.4 Schools of (Technical) Thought 100

4.5 Technical Analysis and Currency Market Practitioners 102

Part Two Regimes and Crises 105

5 Exchange Rate Regimes: Fixed or Floating? 107

5.1 An Emerging World 108

5.2 A Brief History of Emerging Market Exchange Rates 109

1973–1981 109

1982–1990 109

1991–1994 109

1995– 109

5.2.1 The Rise of Capital Flows 110

5.2.2 Openness to Trade 111

5.3 Fixed and Pegged Exchange Rate Regimes 111

5.3.1 The Currency Board 112

5.3.2 Fear and Floating 112

5.3.3 The Monetary Anchor of Credibility 113

5.4 Exchange Rate Regime Sustainability—A Bi-Polar World? 114

5.5 The Real World Relevance of the Exchange Rate Regime 116

5.6 Summary 118

6 Model Analysis: Can Currency Crises be Predicted? 119

6.1 A Model for Pegged Exchange Rates 120

6.1.1 Phase I: Capital Inflows and Real Exchange Rate Appreciation 120

6.1.2 Phase II: The Irresistible Force and the Moveable Object 121

6.1.3 Phase III: The Liquidity Rally 123

6.1.4 Phase IV: The Economy Hits Bottom 124

6.1.5 Phase V: The Fundamental Rally 125

6.2 A Model for Freely Floating Exchange Rates 128

6.2.1 Phase I: Capital Inflows and Real Exchange Rate Appreciation 128

6.2.2 Phase II: Speculators Join the Crowd—The Local Currency

Continues to Rally 128

6.2.3 Phase III: Fundamental Deterioration—The Local Currency

Becomes Volatile 129

6.2.4 Phase IV: Speculative Flow Reverses—The Local Currency

Collapses 130

6.3 Summary 133

Part Three The RealWorld of the Currency Market Practitioner 135

7 Managing Currency Risk I—The Corporation: Advanced

Approaches to Corporate Treasury FX Strategy 137

7.1 Currency Risk 138

7.2 Types of Currency Risk 140

7.2.1 Transaction Risk 140

7.2.2 Translation Risk 140

Example 141

7.2.3 Economic Risk 142

7.3 Managing Currency Risk 143

7.4 Measuring Currency Risk—VaR and Beyond 143

7.5 Core Principles for Managing Currency Risk 144

7.6 Hedging—Management Reluctance and Internal Methods 146

7.7 Key Operational Controls for Treasury 147

7.8 Tools for Managing Currency Risk 148

7.9 Hedging Strategies 150

7.9.1 Hedging Transaction Risk 150

7.9.2 Hedging the Balance Sheet 150