A number of emerging market currencies have made significant moves lower recently, presenting quantitative macro traders with the question of whether there may be positive expectancy positions to be taken in any of these currencies. While there are conflicting analyses with regard to some of these currencies, the answer for me currently is that it makes sense to be long the South African rand and short the Russian ruble and the Brazilian Real.
The Chicago Mercantile Exchange has futures contracts with active screen trading in a number of emerging market currencies, including the Indian rupee, the Brazilian real, the Mexican peso (which is highly liquid and some consider now to not be an emerging market currency), the Russian ruble and the South African rand. I will limit my analysis here to these currencies since they are the most accessible via CME futures contracts.
Historically, a major fundamental driver for currency exchange rate movements has been relative interest rates. Currencies of countries with relatively high interest rates have frequently tended to appreciate against currencies of countries with relatively low interest rates, as a result of investors generally selling lower yielding assets in the low interest rate countries and buying higher yielding assets in the high interest rate countries. When this phenomenon occurs, a trader that is long the high interest rate currency and short the low interest rate currency will not only benefit from the directional change in exchange rates but will also earn the "carry" from the difference in the interest rates. This carry return manifests itself in the difference between forward rates built into the pricing of derivatives the trader uses to implement the position (the futures contracts in the case of the CME products I described above), and is generally economically equivalent to the return the trader would have earned if the trader had borrowed currency in the low interest rate country, converted that currency into the high interest rate currency, and then lent the high interest rate currency at the rate available in the high interest rate country while continuing to owe the lender in the low interest rate currency.
Thus, for currencies of emerging market countries with typically high interest rates (note that most but not all emerging market countries have relatively high interest rates), the above analysis will indicate that a speculative trader should be long those currencies and short low (or even negative in the current environment) interest rate currencies such as the euro, the Swiss franc and/or the yen. Each of the CME listed emerging market currencies I described above has interest rates significantly higher than those in the lower interest rate developed market countries, so this interest rate based analysis would indicate a bullish view on all of the emerging market currencies I described with active trading on CME.
However, another, momentum-based approach such as that that I employ, takes a more comprehensive tack and analyzes the recent total return of the relevant currency. This total return analysis incorporates not only carry but also directional price movement resulting from the actual recent changes in exchange rates. If the recent total return of a currency has been negative notwithstanding a significant positive carry, then a quantitative trader may decide that the substantial downward directional price momentum indicates some sort of weakness that the trader should interpret as a precursor to future weakness and thus an indication for the trader to not have a position in or to be short the currency rather than long.
One important benefit to this total return based momentum approach is risk management related. When a quantitative trader applies a momentum approach properly, it generally enables the trader to close losing positions at points allowing the trader to avoid sustaining larger losses that would require higher future gains to recover from. In contrast, a trader making decisions based purely on carry may stay with a losing position as long as the carry remains substantially positive, and could in theory sustain larger losses if the high interest rate currency depreciates substantially.
In the current environment, the total return of the South African rand has been relatively strong over the last year, meaning that the combination of carry and exchange rate change has made it a profitable currency to have been long through derivative contracts over that time. In this case, there has been both positive carry return and positive directional price gains as the South African rand strengthened over the last year against the US dollar. This recent strong momentum tells me that it may be a good environment to be long the rand, so I currently have a long position in that currency.
However, in the case of the Brazilian real and the Russian ruble, substantial recent price weakness has completely overcome the carry return and resulted in a significant negative total return over the last year. This weakness is large enough that it tells me the better position may actually be to bet against those currencies, and thus I am currently short the real and ruble. Because short positions have less profit potential and larger risk (a short position theoretically has unlimited risk), I have sized these short positions significantly smaller than the long rand position.
Regarding the Mexican peso and the Indian rupee, recent total return has been roughly flat as weak price movement has generally offset carry return. The flaccid recent total returns tell me I want to avoid the peso and rupee for now, so I am flat those markets.
Note that I am a big believer in portfolio diversification, and so these three emerging market currency positions that I currently maintain represent a small portion of my overall portfolio of positions. Each of these positions has points where I will exit the position if it moves sufficiently adversely (generating losses) or profitably (generating profits). And I have sized the positions in a manner to attempt to balance the risk against the other positions in the portfolio.
Finally, while I believe each of these positions has a positive expectation, it is also important to note that these positions have a significant risk of loss. I am not advocating others to take these positions, and in fact will state that trading in futures generally and emerging market currencies specifically is not appropriate for all investors. Instead, I aim for this analysis helps one understand my decision making processes as I go about constructing my portfolios.
The Chicago Mercantile Exchange has futures contracts with active screen trading in a number of emerging market currencies, including the Indian rupee, the Brazilian real, the Mexican peso (which is highly liquid and some consider now to not be an emerging market currency), the Russian ruble and the South African rand. I will limit my analysis here to these currencies since they are the most accessible via CME futures contracts.
Historically, a major fundamental driver for currency exchange rate movements has been relative interest rates. Currencies of countries with relatively high interest rates have frequently tended to appreciate against currencies of countries with relatively low interest rates, as a result of investors generally selling lower yielding assets in the low interest rate countries and buying higher yielding assets in the high interest rate countries. When this phenomenon occurs, a trader that is long the high interest rate currency and short the low interest rate currency will not only benefit from the directional change in exchange rates but will also earn the "carry" from the difference in the interest rates. This carry return manifests itself in the difference between forward rates built into the pricing of derivatives the trader uses to implement the position (the futures contracts in the case of the CME products I described above), and is generally economically equivalent to the return the trader would have earned if the trader had borrowed currency in the low interest rate country, converted that currency into the high interest rate currency, and then lent the high interest rate currency at the rate available in the high interest rate country while continuing to owe the lender in the low interest rate currency.
Thus, for currencies of emerging market countries with typically high interest rates (note that most but not all emerging market countries have relatively high interest rates), the above analysis will indicate that a speculative trader should be long those currencies and short low (or even negative in the current environment) interest rate currencies such as the euro, the Swiss franc and/or the yen. Each of the CME listed emerging market currencies I described above has interest rates significantly higher than those in the lower interest rate developed market countries, so this interest rate based analysis would indicate a bullish view on all of the emerging market currencies I described with active trading on CME.
However, another, momentum-based approach such as that that I employ, takes a more comprehensive tack and analyzes the recent total return of the relevant currency. This total return analysis incorporates not only carry but also directional price movement resulting from the actual recent changes in exchange rates. If the recent total return of a currency has been negative notwithstanding a significant positive carry, then a quantitative trader may decide that the substantial downward directional price momentum indicates some sort of weakness that the trader should interpret as a precursor to future weakness and thus an indication for the trader to not have a position in or to be short the currency rather than long.
One important benefit to this total return based momentum approach is risk management related. When a quantitative trader applies a momentum approach properly, it generally enables the trader to close losing positions at points allowing the trader to avoid sustaining larger losses that would require higher future gains to recover from. In contrast, a trader making decisions based purely on carry may stay with a losing position as long as the carry remains substantially positive, and could in theory sustain larger losses if the high interest rate currency depreciates substantially.
In the current environment, the total return of the South African rand has been relatively strong over the last year, meaning that the combination of carry and exchange rate change has made it a profitable currency to have been long through derivative contracts over that time. In this case, there has been both positive carry return and positive directional price gains as the South African rand strengthened over the last year against the US dollar. This recent strong momentum tells me that it may be a good environment to be long the rand, so I currently have a long position in that currency.
However, in the case of the Brazilian real and the Russian ruble, substantial recent price weakness has completely overcome the carry return and resulted in a significant negative total return over the last year. This weakness is large enough that it tells me the better position may actually be to bet against those currencies, and thus I am currently short the real and ruble. Because short positions have less profit potential and larger risk (a short position theoretically has unlimited risk), I have sized these short positions significantly smaller than the long rand position.
Regarding the Mexican peso and the Indian rupee, recent total return has been roughly flat as weak price movement has generally offset carry return. The flaccid recent total returns tell me I want to avoid the peso and rupee for now, so I am flat those markets.
Note that I am a big believer in portfolio diversification, and so these three emerging market currency positions that I currently maintain represent a small portion of my overall portfolio of positions. Each of these positions has points where I will exit the position if it moves sufficiently adversely (generating losses) or profitably (generating profits). And I have sized the positions in a manner to attempt to balance the risk against the other positions in the portfolio.
Finally, while I believe each of these positions has a positive expectation, it is also important to note that these positions have a significant risk of loss. I am not advocating others to take these positions, and in fact will state that trading in futures generally and emerging market currencies specifically is not appropriate for all investors. Instead, I aim for this analysis helps one understand my decision making processes as I go about constructing my portfolios.