In April 2000, the euro hit its lowest ever point against the dollar, touching 89c in Asian intra-day...
The euro's fall is an impressive example of a major, albeit volatile, currency trend, but it is in no sense unique.
All currencies undergo price trends from time to time, some of them lasting many months. For example, between the second quarter of 1996 and the third quarter of 1998, the Japanese yen declined over 40% against the dollar.
In a similar example of dollar strength, from the third quarter of 1998 through to the present the Swiss franc has fallen by over 35%, notwithstanding a period of high volatility between last July and October.
For the majority of investors, such trends are of academic interest except when travelling or because they impact on the performance of investments held in non-domestic currencies. Recent dollar strength, for example, has added dramatically to the returns achieved by Euroland investors holding US equities.
The analysis of current trends, their initiation, development, longevity, volatility and termination is not particularly complex, given today's computing power. However, the profitable business of anticipating a sustained break-out from a trading pattern or recognising that a move is coming to a close is rather more difficult.
This difficulty is not unique to currency markets. But there are other issues which are foreign exchange specific and which may explain why comparatively few investment managers are active in this sector despite the extraordinary liquidity (turn-over regularly touches the equivalent of $1.5 trillion a day). These include the fact that whatever the currency base, a successful fund or programme cannot be anchored in one currency if it is to be fully responsive to all market opportunities. In addition, all currency trading is double-edged - one currency's weakness is another's strength.
From a practical dealing perspective, cross-trade rates between secondary currencies are commonly quoted through the dollar which at the same time widens the bid/ask spread and may undesirably reveal a manager's positions.
Equally, when it comes to trading secondary currencies, the huge overall turnover figures are misleading - on certain days and at certain times, liquidity can be tight and an active investment manager can periodically find itself responsible for an uncomfortably high proportion of total volume.
That said, successful currency managers accept the constraints of the foreign exchange markets as part of the rules of the game.
One systematic strategy is price trend following. Here, purchases or sales are made when prices appear to depict a particular trend. Positions are closed out when the trend or market conditions change - for example when volatility increases - or when there appears to be a high probability of change.
This approach leads to the execution of a comparatively low number of trades per year with a preferred focus on long-term profitable trends rather than a series of short duration positions which carry with them a higher cost of execution.
There should be a consistency in the approach to construction and implementation of every investment programme. Obviously systems vary, but generally the most important areas are time series of prices, usually closing prices, gathered for varying periods of the past.
This class should then be subjected to an intensive battery of tests that indicate the pattern of returns, their variability over time and the risk in both dollar and percentage terms to a portfolio during periods of declining returns.
A further critical process is intensive analysis to determine risk and return probabilities. The techniques include assessment of standard deviation of monthly returns, individual trade analysis for average wins, losses and profitability per trade.
Varying calendar period analysis should be undertaken to measure performance and gauge continuity. Sharpe ratios (reward-to-risk measurements), drawdowns of monthly returns and the sustainability of the pattern of returns should be monitored.
A further risk management feature is that a low percentage - typically 1% - of trading capital is staked on any one trade. By taking a strict systematic approach, money can regularly be extracted from the foreign exchange markets.
Christopher Cruden is managing director at Tamiso & Co, New York
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