Variance risk premiums, volatility and FX returns

December 28, 2014

Variance risk premiums mark the difference between implied (future) and past volatility. They indicate changes in risk aversion or uncertainty. As these changes may differ or have different implications across countries, they may cause FX overshooting and payback. The effect complements the simpler argument that rising currency volatility predicts lower FX carry returns. Academic papers support both effects empirically.

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Official flows and consequences for FX markets

November 8, 2014

A new IMF paper shows empirically that official currency interventions affect external imbalances and, by implication, exchange rate misalignments. There is a short-term flow impact, which is strongest when capital mobility is low. And there is a medium-term portfolio balance impact, which is strongest when capital mobility is high. Both effects are intuitive and offer lessons for FX trading strategies.

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Self-fulfilling and self-destructing FX carry trades

November 2, 2014

When foreign exchange trading meets inflation-targeting self-fulfilling investment strategies are possible. A technical paper by Plantin and Shin shows that positive FX carry encourages capital inflows that reduce inflation and allow monetary policy to condone a domestic asset market boom. Thereby FX carry strategies create their own implicit subsidy and self-validating flows. Conversely, a reversal of such flows is self-destructing.

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Disaster risk and currency returns

November 1, 2014

A paper by Farhi and Gabaix explains how fear of global crisis leads to outperformance of risky versus less risky currencies. Carry trades have worked historically, because high risk premia conditioned both high interest rates and subsequent revaluation. As a practical conclusion, gaps between perceived risk (often based on historical variances and correlation) and actual fundamental risk (as indicated by fundamental macro factors) are key value generators in FX strategies.

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When currency strength and credit booms feed on each other

September 6, 2014

A  paper by Bruno and Shin illustrates how global banks drive lending booms in local currency markets. Most importantly, they explain how currency strength fuels rather than curbs financial expansion in small and emerging economies, leading to escalating dynamics. Conversely, dollar strength can trigger a tightening spiral. Empirical evidence seems to support the point.

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Understanding capital flow deflection

June 28, 2014

A new academic paper asserts strong empirical evidence for capital flow deflection: one country’s capital inflow restrictions re-direct capital flows to other countries with similar economic characteristics. While the paper investigates from a policymaker angle, it would be relevant for international macro trading strategies.

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The idea of uncovered equity parity

May 31, 2014

Uncovered equity parity explains how equity portfolio rebalancing affects exchange rates. Outperformance of foreign stock markets, whether through the exchange rate or stock prices, leaves investors with excess exchange rate exposure. The reduction of this exposure then puts depreciation pressure on the foreign currency. A new Federal Reserve paper presents evidence for the essential parts of that theory.

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Volatility insurance and exchange rate predictability

January 26, 2014

The cost of insuring against currency volatility can be measured as the difference between (options-based) implied volatility and (swaps-based) forward expected realized volatility. A case can be made that this insurance premium determines how much exposure risk-averse institutions are willing to accept. A new paper and blog post by Della Corte, Ramadorai, and Sarno claim that variations in volatility insurance costs can be the basis for a profitable currency trading strategy.

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Current accounts and foreign exchange returns

November 6, 2013

A research report by Jens Nordvig and his colleagues at Nomura shows that external (current account) surpluses have been a poor indicator of currency performance over the past 20 years. External deficits are often the consequence of growth outperformance, decreasing country risk premiums and capital inflows, and hence may be associated with currency strength rather than currency weakness.

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The FX carry-equity nexus

March 16, 2013

Galsband and Nitschka claim that the outperformance of high-carry currency trades over the past 30 years reflects a premium for correlation with shocks to equity cash flows. While the finding may sound trivial, its implications are important. In particular, in connection with the negative impact of currency strength on local equity, the fx carry-equity nexus would imply that carry countries’ local-currency equity returns should outperform in crisis times, as they are buffered by the exchange rate and become a better diversifier, when all other correlation increase.

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Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.

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