Speculate to Accumulate – When Currency Trading Pays Dividends

The global economy post-2008 would not appear to be the most fertile territory for currency trading, at least with a view to making any significant profit. The increased instability that has instilled itself in even the more reliable of economies would appear on paper to be an even more fraught operation than was already the case. Research into and practice of such trading has long been based upon the assumption that investing in high-interest rate currencies and funding transactions with low-interest rate currencies would offset one another. In short, the potential differentials in such trading would be covered or the potential returns would be less than substantial. Not so, according to recent exploration that challenges the myth of “uncovered interest rate parity”.

The currency carry trade phenomenon

One constant in the currency trade landscape is the omnipresent potential impact of price appreciations and depreciations. Timing is key to any such an investment + funding strategy and therefore correctly testing the temperature of the markets and knowing when to buy and sell is of tantamount importance, as is the overall behaviour of the speculators pulling the strings. The phenomenon of currency carry trading, whereby profits can be made where one would otherwise expect potential losses to simply be catered for, is highly reliant upon the key concept and reality of speculator behaviour. Factor in the possibility of creating a level of dependency between currencies of differing interest rates and stability and it is possible to leverage opportunities within the context of currency market volatility to make significant gains.

Knowing where, how and when to cash in

Previous research into the field has been hinged upon the notion of “uncovered interest rate parity”, whereby the expected change in currency rates is vouched for by interest rate fluctuations. However, the phenomenon of currency carry trading, whereby selling a high interest rate currency forward and buying a low interest rate currency forward means that the higher selling rate outweighs potential adverse exchange rate changes, creating significant profit opportunities. When such “safe bankers” as the low-interest, ever-stable Japanese Yen or Swiss Franc can be used against the more volatile, higher-interest currencies such as the South African Rand or Brazilian Real, the chances of cashing in are higher still. But timing and speculator behaviour remain crucial in order to reap the best possible dividends.

Exploring dependency between currencies

To increase the chances of such complex operations of being successful, investment strategies designed to correlate and co-variate currencies are now in practice, meaning that market movements are inter-linked with the result that the fluctuations of one currency can have a drag or pull effect on one another and involve the various high- and low-interest markets in a dynamic whereby positive or negative variations can ultimately lead them to rising or falling in tandem. It is down to the speculator to handle this fine balance in the best interests of all.

To test this theory and increasing practice, a two-part study was recently conducted involving an initial pool of 8 countries (Australia, Canada, Japan, New Zealand, Norway, Switzerland, UK, and the Eurozone). Also included were the developing countries of Singapore, Taiwan, India, Mexico, South Africa, Brazil, and Turkey. Daily settlement prices for each currency exchange rate, as well as the daily settlement price for associated 1 month forward contracts, were applied over the period 04/01/99 – 29/01/14 from the perspective of an American investor, in line with the majority of research into the area, and feeding in speculative flow data generated by the US Commodity Futures Trading Committee. A second phase comprising no fewer than 34 currencies was also conducted over a broader period beginning 02/01/89 up until the same closing date.

When volatility equals opportunity

Whilst research into currency carry trade has thus far suggested that such an investment strategy provides limited ROI, the two-step empirical, microeconomic study recently conducted implies that such speculative behaviour can not only impact individual currency returns but also create positive currency dependence. Whilst the biggest dividends can be reaped in times of greater market volatility, it also suggests that lower-risk periods may also present opportunities for fruitful investment, for all countries and currencies involved. Central banks and speculators are therefore well advised to create such economic relations between countries and currencies, whilst remaining mindful of the timing of such operations. Market risk is prevalent and a reality to which they must remain ever-sensitive. In addition, the gap between investment and funding must always be anticipated and accounted for. However, by pooling together currencies at varying interest rates, market volatility should first and foremost be viewed as an opportunity to be exploited rather than avoided.

This article draws inspiration from the paper Violations of uncovered interest parity and international rate dependences, written by Matthew Ames, Guillaume Bagnarosa and Gareth W. Peters and published in The Journal of International Money and Finance 73 (2017).

Guillaume Bagnarosa is an assistant professor of Finance and Accounting at Rennes School of Business, France. His research interests include Asset Pricing, Risk Management, Financial Econometrics, Asset Allocation, and Hedge Funds