By Ajay Shah, on October 29th, 2010
In a few minutes, NSE and USE will start trading in currency options. This will be the first exchange-traded options in India on a non-equity underlying.
Currency options are obviously useful as a risk-management tool. I feel that futures are nice simple linear contracts: they ask the person to make only one decision — are you long or are you short. But once a futures position is entered into, the person needs the ability to manage the position since daily marking-to-market is done, and since there can be large losses for either the futures long or the futures short.
Compared with this, long positions on call or put options appeal to the kind of person that is willing to think carefully about a position at the outset, but after that it is fire and forget. This better describes the life of many firms exposed to currency risk, particularly those with relatively weak treasuries.
Currency options have, of course, been traded OTC for some time now. But there are real problems with this market. Customers have sometimes been ripped off by banks on pricing, given the lack of a liquid and transparent comparison point. While currency options are offered by banks to customers, there is not much by way of an inter-bank market.
As far as I know, there is relatively little by way of a build-up of human and systems capability in the banks for currency options trading (whether OTC or on exchange).
In contrast, there is a remarkable build-up of human and systems capability in the world of Nifty options trading. Options on Nifty have shaped up as one of the biggest options markets in the world. This involves end-users who think and trade options, staff working for securities firms who understand options (and understand issues about their credit risk when their customer has an options position), analytical software systems, and (most importantly) algorithmic trading systems. Options trading inevitably involves trading in a large number of underlyings. Strong computer systems which are able to think about, and place orders in, all the underlyings at one shot are of essence in achieving option liquidity. Such capabilities are now found in the world of Nifty options, and are absent in banks or in the OTC currency options market.
It is fairly easy for a person trading Nifty options to move to trading currency options. Hence, the brainpower and systems that have made Nifty options one of the world’s top contracts will easily be able to move to currency options trading, and make it work. I expect that the securities firms who dominate Nifty options trading will now dominate currency options trading.
I think three kinds of stories will now kick in:
- Liquidity in currency options will fuel liquidity in currency futures, and vice versa. Corporate hedgers will be more interested in either, given that the other is also a possibility.
- Skills and systems from Nifty options will flow into currency options. Banks will be able to rapidly bulk up their options capabilities by recruiting from the world of Nifty options, and by purchasing the software systems that have sprung up in that space.
- Conversely, trading in both currency options and Nifty options will generate an increased business size for people who build knowledge and systems for options; it will also improve knowledge of options trading through an understanding and comparison of the nuances of two different underlyings. The number of FRM and PRM certified people in India will go up.
Of great interest will be the question of currency volatility. On one hand, the currency options market will generate an implied volatility for the currency, which will represent a market-based forecast for what future currency vol will be. This will be a big new piece of information which will inform macro policy and monetary policy, and thus diminish the extent to which we are flying blind in thinking about Indian macroeconomics. In recent years, RBI has mostly stayed off from foreign exchange trading in the currency market, so the volatility of the INR/USD is a true market volatility. If, in the future, RBI thinks that it wants to give subsidised currency risk management services to the private sector, one way in which it would be able to do that is to do `intervention’ on the currency options market so as to force down the implied vol of the market. I.e., RBI would sell ATM calls and ATM puts and thus drive down that price, and thus give cheaper risk management services to the market. This would represent the first operational intervention strategy for RBI through which it can pursue the goal of reducing volatility without distorting the INR/USD exchange rate. If RBI gets into actively trading the currency market again and trying to push the rupee into a de facto pegged exchange rate, we will see this clearly in the currency options market as a sharply reduced implied vol. 
By Bron Suchecki, on October 22nd, 2010
WHAT OTHERS ARE THINKING
An example of “gold blindness” from Barry Eichengreen, Professor at the University of California in his recent article on reserve currencies:
“… the view that there can be just one international and reserve currency at any point in time is inconsistent with history. Before 1914, there were three international currencies: the British pound, the French franc, and the German mark. The dollar and the pound then shared international primacy in the 1920’s and 1930’s.”
While there may have been many paper currencies, he ignores the fact that in times past the various versions of gold standard in operation meant that gold was in effect the underlying sole reserve currency.
He also has an interesting view of central bankers, stating that their “… reserve managers do not have the high-powered financial incentives of hedge fund managers to seek to maximize returns. … They have social responsibilities, and they know it. This means that they have less incentive to herd – to buy or sell a currency just because everyone else is buying or selling it. They can adopt a longer time horizon, because, unlike private fund managers, they do not have to satisfy impatient investors. Compared to private investors, then, central-bank reserve managers are more likely to act as stabilizing speculators.”
Well, in respect to gold I think the documented switch by central banks in general from selling gold to buying it could be used to make a case that they are herding along with impatient investors. In fact, it would probably be more accurate to say they are following rather than herding, as central banks were selling all the way through gold’s 10-year bull market, only switching to net buying in 2009. Question is why the switch? For “social responsibility” reasons or as (un)stablising speculators?
By Eldon Mast, on April 14th, 2010
Singapore Dollar Jumps, South Korean Won Up, and Intel Beats Yet Again.
The Singapore government announced early Wednesday that its economy is likely to expand by 9% this year. Coincidentally, South Korea also announced that its economic growth is accelerating. Meanwhile, economists surveyed by Bloomberg have estimated that China’s economy probably grew by 11.7% in the first quarter, the fastest rate in nearly three years. Stocks rallying in early Wednesday trading as Intel’s global sales performance release late Tuesday continues to show Intel on a blistering growth trajectory. Intel shares rose as much as 3.6% in extended trading after the chip giant beat the street yet again.
The growth results in Singapore and the largest reported drop in Korean unemployment in a decade underscored Asia’s leadership in the global recovery. Stateside, Intel’s new forward-looking estimates punctuate a recovery that is taking solid root.
“Companies are demonstrating that economic conditions are improving, and the data points to an ongoing theme of recovery,” said Prasad Patkar, at Platypus Asset Management Ltd. in Sydney.
“Risk appetite is improving, buoyed by solid economic data and corporate profits,” said Norihiro Tsuruta, chief strategist in Tokyo at Shinko Research Institute Ltd.
And the U.S. Economic engine driven primarily by retail sales is also revving up. On Tuesday the ICSC-Goldman report registered a very strong plus 4.0 percent year-on-year pace. According to Goldman forecasts, strength in April will prove to be a key indication of U.S. consumer strength. Their forecasters expect a “very healthy” plus 4.0 percent year-on-year rate for the months of March and April combined.
An acceleration in the U.S. GDP would mean (by definition) that Q1 GDP will be above the rate measured in Q4.
By Trace Mayer, on March 12th, 2010
The IMF gold has serious geo-political ramifications in the background because of the nature of foreign exchange reserves, credit default swaps and gold. Wikipedia:
South Korea and Japan are both home to large numbers of United States troops and neither are going to invite a nuclear attack. The Kuomintang, which the US backed, retreated to Taiwan when they lost power and China still asserts their ownership over the tiny island and the US continues to honor their agreement to defend Taiwan. Russia has been discharging dollars and acquiring gold while Brazil is bucking the buck. Neither China nor India have significant reported physical gold holdings; they need a hedge to the major currency illusions. In my book The Great Credit Contraction the liquidity pyramid represents the FRN$ will be the last major currency to evaporate.
The Euro’s evaporation has increased and ultimately has only one outcome. Sure, Germany wants to retain its voice on the world stage and is faced with a Hobson’s choice of bailing out Greece and eventually the other unproductive free-riding members of the Euro or let the Euro evaporate and lose their relevance on the world stage because Germany only matters if Europe as a whole matters.
CREDIT DEFAULT SWAPS
But the Damocles sword of credit default swaps, which is falling toward’s Greece, can, ultimately, be measured only against gold because gold is no-one’s liability. Just like the Chinese have feigned their interest in acquiring gold; many sophisticated investors have feigned ignorance of gold’s monetary role. Many sophisticated investors, like George Soros who broke the Bank of England doubled his gold position in Q1 2010, Paul Tudor of Tudor Investments, John Paulson, David Einhorn, Eric Sprott, Jim Rogers, Peter Schiff, John Embry and many others are likewise allocating their capital based on the premise that gold is a major world currency.
Even Janet Tavakoli, a former adjunct associate professor of derivatives at the University of Chicago’s Graduate School of Business, and author of six books on derivatives recently wrote:
U.S. credit default swaps currently trade in euros. After all, if the U.S. defaults, who will want payment in devalued U.S. dollars? The euro recently weakened relative to the dollar, and market participants are calling for contracts that require payment in gold. If they get their way, speculators on the winning side of a price move will demand collateral paid in gold.
The market can create an unlimited number of these contracts very rapidly. The U.S. wouldn’t have to ever default to trigger a major disruption in the gold market.
The fiat currency and fractional reserve banking system is merely a confidence game built on an illusion and fraud. Fiat currency is to be valued like the common stock of a government and in gold. As such the current system will end and holder’s of capital will demand to be shown the money. Just ask Harry Reid about karma.
The price of gold in evaporating currencies would not so much create a disruption in the gold market as cause a serious loss of confidence in the current system which would result in a tremendous increase in gold’s liquidity, hopefully through use by individuals in ordinary daily activities like what happened in Zimbabwe last year. After all, who really needs to use fiat currency illusions and why? In this case, we are seeing both China and India demanding to see the IMF’s gold, the Damocles sword jitters and there is only one protection. Assets with intrinsic value.
By Ajay Shah, on March 30th, 2009
Under a floating exchange rate, firms have a correct estimate of how risky it is to have unhedged foreign currency exposure. When a central bank artificially distorts currency volatility downwards, as RBI has often done, this gives out the wrong incentives to take on foreign currency risk. Now firms in India are lobbying that they be permitted to delay marking to market of exchange rate losses in the aftermath of a surprising rupee depreciation. Mahesh Vyas has facts on Indian firms and currency exposure, in the immediate context of the debate on fudging AS 11 disclosures. Also see editorials in Financial Express and Business Standard.
By Cheryl Grey, on November 11th, 2008
When the U.S. government refused to bail out Lehman Brothers and no buyer could be found for the tottering investment bank, traders and investors around the world realized something terrifying: their profits—worse yet, their capital—were at risk, and the Fed’s lack of action proved no one was going to save them.
Results Round One
The result was panic. Faced with massive losses, these international investors yanked their funds from commodities, stocks and other investment vehicles in emerging markets around the globe and bought bonds offered by developed nations. Any investment seen as riskier than a 90-day T-bill was spurned in what has come to be called “the flight to quality.”
The result of that result was the unwinding of carry trades. In that scheme, traders take out loans in nations with low interest rates (such as Switzerland at 2.0%, the U.S. at 1.0% or Japan at 0.3%) and invest the funds in nations with high ones (such as New Zealand at 6.5%, South Africa at 15.5% or Iceland at 18%), thus earning the “spread” between those rates. But currency fluctuations, caused by shifting interest rates or decreasing economic potential in the investment nation, put both profits and capital at risk, and during the flight to quality traders dumped these investments and repaid their loans. In the process, the South Korean stock market collapsed 40%, Ukraine’s 60%, Iceland’s 90% (see chart of the Icelandic index above, October 17). The Russian market ceased trading for two days, hoping for stability to emerge; it didn’t happen.
The next result was the appreciation of the U.S. dollar against every currency in the world with the lone exception of the Japanese yen. Since mid-August, when the unwinding of carry trades began in earnest, JPY has appreciated almost 18% against USD as these international traders “sell” the dollar and “buy” the yen to repay their Japanese loans. The yen rose so high that the affordability of, and therefore the profit from Japan’s exports, slumped, with Toyota’s profits shrinking 69% in the most recent quarter and Sony’s by 72%.
Results Round Two?
And that’s the good news.
With the worst of the flight to quality complete, most major currencies appear to be stabilizing against USD, albeit at lower than anticipated levels. The Euro, which was worth an historic high of $1.60 as late as July 14, lost $0.37 in value by October 28, or 23%. The U.K. pound, which was as high as $2.11 a year ago, currently trades at $1.56, down 26%. These currencies are also shifting in value against each other. The exchange ratio between the Euro and the Swiss franc, another traditional safe-haven currency in times of financial stress, has fallen 12.6% since July 31.
In terms of international finance, these are huge moves, particularly for emerging economies. With the rise of globalization, loans of all varieties—corporate, individual, inter-governmental—are now made across national boundaries and across currencies. As currencies shift into new relative value ranges, the payment terms of these loans shift to follow, meaning that Swiss loans to Euro-funded nations are now 12.6% more expensive than they were three months earlier.
Current estimates place 90% of all Hungarian mortgages written since 2006 in Swiss francs. With the Hungarian forint down 17%, these mortgages are ballooning in cost just as their adjustable-rate counterparts did in the U.S. when the Fed raised the prime interest rate. The financial world already knows the rest of that story. Rather than waiting for the rush of defaults and foreclosures both corporate and domestic, the International Monetary Fund, European Central Bank and World Bank loaned Hungary 20 billion Euros (US$25.5 billion) on October 29. Loans to Ukraine, Pakistan, Iceland and other nations are following quickly.
But similar circumstances in Romania, Bulgaria, Serbia, Lithuania, Latvia, Croatia, Poland, Slovakia, Belarus and the Czech Republic mean the second round of the financial crisis may be happening across the Atlantic. Even worse, the story is repeated in parts of Asia and in Central and South America. All told, a total of US$4.7 trillion in loans cross these international borders, and Western European banks hold three-quarters of those notes, an amount that dwarfs U.S. banks’ exposure in the first round of that crisis. In Austria alone, bank exposure to these notes is 85% of national gross domestic product and in Switzerland it’s 50%.
Steve Forbes may believe the worst is over. Europe doesn’t necessarily agree.
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