Emerging markets currencies step into the limelight

Foreign exchange markets have been enjoying renewed investor interest, with emerging markets currencies and options the focus of much activity. The growth of e-commerce and improvements in risk management methodology are also changing how banks offer FX to clients.

Tim Owens, global head of the currency and commodity solutions group at JPMorgan, says that in the past couple of years investor interest in FX as an asset class had broadened, with hedge funds, institutional investors and retail investors all participating. “Investors are taking macro, thematic views on currencies, for example, by putting on trades based on their view of the convergence of eastern European currencies towards the euro,” he says.

Basket of currencies

Index products that are being promoted by a number of banks allow investors to express these views using a basket of currencies.

One of the most pronounced current trends in the FX markets is the focus on emerging market currencies. Volatility in the G7 currency block has fallen and investors are looking at emerging market currencies as an alternative. Mr Owens says he sees growing appetite for trading the full range of FX exotic options with emerging market underlyings.

Challenges for banks

However, this raises a number of challenges for the banks that structure these products. “Liquidity is an obvious consideration, compared to the liquidity in G7 currencies,” he points out. “So are the different dynamics of emerging market currencies, which may, for example, be pegged to another currency.”

Thanos Papasavvas, head of currency management at Credit Suisse Asset Management, agrees that investment managers have been attempting to gain alpha through emerging market and volatility strategies. “Emerging market currencies are not closely correlated to other major currencies, which have been range-bound for the past couple of years,” he says. “This ranging, with no real trend, has meant that people have been using volatility strategies to gain alpha. Both these strategies are definitely getting more buy-side exposure.”

FX diversification

Credit Suisse Asset Management looks at 10 emerging market currencies, to get a good mix across regions. “This allows you to capture intra-regional plays and get diversification, as this mix of currencies (Latin American, South African, Asian and eastern European) is not correlated. Correlation on emerging market currencies has been reduced a lot since the late 1990s,” says Mr Papasavvas. “Emerging markets have developed, and are more transparent, while investors are more educated in how they look at them. Liquidity is better, and different factors drive emerging market economies and currencies.”

Steve McMillan, GFI’s senior managing director and head of Europe, describes the growth in emerging markets FX trade as dramatic. “Both the buy and sell side are looking for volatility opportunities and, although we have seen some more volatility on the dollar recently, most people are still focusing on volatility in emerging markets currencies,” he says.

Mr McMillan says there has also been an increase in the volume and variety of exotic option structures, especially in Asia. A more sophisticated client base is now trading FX, allowing more complex and esoteric structures to be traded. “Whereas in recent years the focus of hedge funds, for example, has been on credit markets, it has now shifted towards currencies,” he says.

The type of options being traded include long-dated options, out to about 15 years in the inter-dealer market and for as long as 50 years on the buy side. While the size of the market is unknown, Mr McMillan says it is a very fast growing area “with people feeling more comfortable about extending the period of optionality because they are able to manage risk in a more controlled way than in the past”.

Better risk management

The greater confidence that has allowed longer-dated options to flourish and new participants to consider entering the market is due, at least partly, to advances in the field of FX risk measurement and management. In particular, steps forward in the quantitative analysis of investor behaviour and how it affects currency trading, and a more dynamic approach to measuring risk over the life of a portfolio, have led to improvements.

Lisa Franks, managing director and head of quantitative FX sales at State Street Global Markets in Boston, says FX risk managers have had to move away from traditional risk measurement methodologies in favour of a more dynamic approach. “Managers cannot afford to measure their risk exposure at the end of a particular time horizon. Now they need to examine their risk profile at any point throughout the time horizon,” she says.