Capital Ideas: Cashing in on Currency

Skittish about using currency for anything but hedging, corporate finance executives are getting an earful from investment managers about the case for global cash markets as a new source of investment returns.

Currency managers buttress their case for currency by pointing to the vast liquidity and gaping inefficiencies of the global cash markets. Those conditions provide the currency-investment managers plenty of chances to exploit market imbalances to generate extra returns, they say.

Consider the alpha potential: The average daily trading value of the global cash markets is $1.9 trillion, dwarfing the world’s most liquid trading
markets. (The New York Stock Exchange, the world’s largest equities market, generates $4.1 billion in daily trading, while the U.S. bond market—
including Treasuries, long-term corporate debt, and municipal debt—spawns $533 billion.)

The inefficiency of currency markets is said to stem from the disparate motives of the various market players. In those markets, for instance, there are corporations trading goods, tourists spending money abroad, investors seeking international exposure, and central bankers hatching monetary policy. “There are few other markets where such a large number of participants are so accepting of price and unconcerned with profit,” Arnott explained in a report he wrote in June.

Unlike the equities market, in which the players seek a profit, currency-market participants behave with other goals in mind. For instance, central banks try to nudge currency exchange rates for macroeconomic or geopolitical reasons, while corporate managers use hedging strategies to protect transaction revenues generated abroad.

Making the case for currency investing, Arnott contends that currency-price movements are more discernible than they’ve been before. That may be a result of what he and other currency advocates see as the market’s new-found maturity.

Currency management, in fact, is relatively new, having burgeoned only after the United States abandoned the gold standard for international trade in 1971. In the ensuing decade, market players, notably in the United Kingdom, spent time getting used to the idea of floating exchange rates. By the time active currency management reached the United States, it was 1988. Thus, the technique “grew up during the 1990s”, adds Bill Muysken, global head of research for Mercer Investor Consulting.

Since then, investors—even some corporate ones—have become aware of currency management and grown more comfortable with the modeling technology used to pinpoint price movement, according to Muysken. Further, greater numbers of currency-investment managers have been pushing their wares. In 2004, for example, Mercer advised clients on 28 currency manager searches, a considerable leap from the seven such searches the firm was under contract for in 2003. Most of the searches involved pension funds.

The managers are making a fairly good case. Besides the heightened quest for returns, actively managed currency offers diversification because currency returns aren’t correlated to the movement of the debt and equity markets, Arnott asserts.

Mercer’s Finney, however, doesn’t believe currency will displace debt or equity in pension fund portfolios any time soon. The decision to invest in currency is company-specific, depending on a plan sponsor’s risk appetite, liability profile, plan maturity dates, and liquidity requirements, he says. If currency is used at all, he and other experts reckon, it’s most likely to crop up as an overlay to protect a portfolio’s international stocks and bonds from currency risk.


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