Currency Markets Jolted After Months of Calm

Currency Markets Jolted After Months of Calm

Volatility Rises as Investors Focus on Interest-Rate Divergence

By ANJANI TRIVEDI and IRA IOSEBASHVILI WSJ

After months of calm, currency markets have sprung back to life, as investors scramble to take advantage of the divergent paths taken by major central banks.

Bigger and more-frequent shifts in the foreign-exchange market are a welcome relief for investors, many of whom struggled to make profitable trades when currencies weren’t moving as dramatically.

Banks, whose currency desks execute trades on behalf of clients and companies, also see revenues grow when choppier markets drive up demand for their services.

“This definitely brightens my day,” said Chris Stanton, who oversees about $200 million at California-based Sunrise Capital Partners LLC. “It’s a welcome return to what feels like a freer market.”

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The size of daily trading swings across currencies has jumped 55% since hitting its lowest in at least a decade on July 31, according to Deutsche Bank AG. During that time, the dollar climbed to a six-year high against the yen, the euro fell below $1.30 for the first time since July 2013 and the pound tumbled to a 10-month low against the dollar. On Wednesday, the Swiss franc saw its biggest drop against the euro in six months.

Driving the price swings is a shift in policies at some of the world’s largest central banks. A burgeoning recovery in the U.S. has brought the Federal Reserve closer to raising rates, a move that would make the dollar more attractive to investors. At the same time, European and Japanese central banks are still trying to kickstart their economies and relying on policies such as bond buying that tend to drive down interest rates and reduce the value of a currency.

Implied volatility, which tracks the price of options used to protect against swings in exchange rates, has surged 45% in September to an eight-month high, according to Deutsche Bank. Higher implied volatility suggests money managers are buying options in anticipation of a more-active market.

Some money managers are buying the dollar ahead of next week’s Fed meeting, where policy makers could send firmer signals on their outlook for interest rates. Mr. Stanton’s fund is betting that the dollar will continue to strengthen against the yen and emerging-market currencies as the Fed gets closer to raising interest rates.

Citigroup Inc., C +1.11% the world’s largest currencies-dealing bank, on Monday said its markets revenue, which includes currency trading, is on track to be roughly flat in the third quarter compared with the same period in 2013, ending a decline that started a year ago.

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Until recently, unusually calm markets had left investors with fewer opportunities to trade and led to the demise of several large currency funds. FX Concepts LLC, founded in 1981 and considered a pioneer in currency investing, closed its doors last year after assets shriveled to $660 million from $14 billion before the financial crisis.

Currency volatility plummeted after the financial crisis, as the world’s biggest central banks cut interest rates to near zero. That gave traders little incentive to try and capture the difference in interest rates between various currencies, a key driver of activity in the foreign-exchange market.

That status quo has started to crack. Minutes from the Fed’s July meeting showed growing support for raising rates, spurring gains in the dollar when they were released in August. Earlier this month, the ECB surprised investors with a rate cut, bringing down the euro. Meantime, the pound tumbled on concerns over the repercussions from Scotland’s possible secession. On Wednesday, the Swiss National Bank said that it could introduce negative interest rates to halt the franc’s rise.

Trading bands of some major currencies have widened this summer, opening the door to bigger profits for investors. So far in September, the dollar is moving on average by 0.70 yen a day, the biggest range since February and up from 0.35 in July. Daily moves in the euro this month are averaging 0.79 U.S. cent, compared with 0.4 cent in July.

“Now, there are more opportunities to make money,” said Masafumi Takada, vice president of currency trading at BNP Paribas SA BNP.FR -0.39% in New York. Business volume at the bank’s New York currency-trading desk has quadrupled since July, Mr. Takada said.

Currency volatility can be a double-edged sword. Investors can profit by riding the dollar’s steady move higher against a variety of currencies. But a sudden reversal—such as a surge in the pound if Scotland votes against independence—could catch traders off guard. Goldman Sachs Group Inc. GS +1.39% took a loss on an options trade involving the dollar and yen about a year ago, people familiar with the matter said. Last summer, the yen’s months-long decline had stalled.

Federal Reserve Chairwoman Janet Yellen attends a Board of Governors meeting at the Federal Reserve in Washington last week. Associated Press

Some traders believe the current bout of volatility may die down. The large moves seen this week are unusual, analysts say.

On Wednesday, the euro fell 0.2% to $1.2917, while the dollar rose 0.6% against the yen to 106.85. The pound rebounded, with the dollar falling 0.64% against the British currency.

“The question is whether or not this much of a jump [in volatility] is sensible,” said Geoff Kendrick, head of foreign-exchange and rates strategy in Asia at Morgan Stanley MS +1.24% in Hong Kong.

Still, many find it hard to imagine that the magnitude of the Fed’s policy shift won’t continue sending waves across currency markets.

“The dollar’s on a tear, and there is more of this to come,” said Kit Juckes, a strategist at Société Générale SA.

—Justin Baer and Saabira Chaudhuri contributed to this article.

Write to Anjani Trivedi at anjani.trivedi@wsj.com and Ira Iosebashvili at ira.iosebashvili@wsj.com

MARC FABER: We’re In A Gigantic Financial Asset Bubble That Could Burst Any Day

MARC FABER: We’re In A Gigantic Financial Asset Bubble That Could Burst Any Day
MAMTA BADKAR
JAN. 14, 2014, 7:02 PM 11,190

As stocks returned a whopping 30% in 2013, there have been growing concerns about a stock market bubble. Especially considering that the rally supported by only meager earnings growth.
While many have made comprehensive arguments showing why stocks are not in a bubble, Marc Faber, author of “The Gloom Boom And Doom Report,” continues to argue that we’re in a bubble that’ll pop as we head for a financial crisis.
In an interview with Bloomberg TV, he says we are in a “gigantic financial asset bubble.” He also thinks the bubble could burst at any moment.
“I think we are in a gigantic financial asset bubble. But it is interesting that that despite of all the money printing, bond yields didn’t go down. They bottomed out on July 25, 2012 at 1.43% on the 10-years. We went to over 3.0%. We’re now at 2.85% or something thereabout. But we’re up substantially. Now, this hasn’t had an impact on stocks yet. In fact, it pushed money into the stock market out of the bond market. But if the 10-years goes to say 3.5% to 4.0%, then the 30-year goes to close to 5.0%, the mortgage rates go to 6.0%. That will hit the economy very hard.”
“[The bubble] could burst before. It could burst any day. I think we are very stretched. Sentiment figures are very, very bullish. Everybody’s bullish. The reality is they’re very bullish because they think the economy will accelerate on the upside. But my view is very different. The global economy is slowing down, because the global economy’s largely emerging economies nowadays, and there’s no growth in exports in emerging economies, there’s no growth, in the local economies. So, I feel that the valuations are high, the corporate profits have been boosted largely because of the falling interest rates.”
This is not a totally new call. Faber has repeatedly said that we’re headed for a 1987-type sell-off.
Faber also said Facebook is a fad and that lower interest rates are punishing savers. Here’s the entire transcript from Bloomberg TV:
———————————–
Faber on the Fed and how far the ‘rubber band can be stretched’:
“We have to distinguish between the financial economy, the financial sector, and the economy of the well-to-do people that benefit from rising asset prices, from rising prices of wines, and paintings and art, and bonds, and equities, and high-end properties in the Hamptons and West 15 here in New York and so forth — and the average person, the typical household, the so-called ‘median household’, or the working class people. And the Fed’s policies have actually led to a lot of problems around the world in the sense that they’re not only responsible, but partly responsible that energy prices are where they are, they’re up from $10 or $12 in 1999 to now around $100 a barrel. Food prices are up and a lot of other prices are up. So on your income, energy prices have very little impact because you at Bloomberg – you, young man – you make so much money. But for the poor people, it has an impact. Some people in the lower income groups, they spend say 30% of their income on energy, transportation, and so forth, electricity and gasoline.”
On whether the Fed is creating a two-class system:
“Correct, largely. The problem is then that you have people like Bill de Blasio, they come in and say: ‘you know what’s the problem? All these rich guys. Because of these rich people, you are poor. They take advantage of you. So, let’s go and tax them.’ The IMF has come out with a paper in Europe that essentially the well-to-do people should pay a 10% wealth task — a one-time wealth tax. I can assure you, a one-time wealth tax, 10%, will become an every-year’s tax eventually.”
On how to help the people on the lower end of the economic spectrum:
“This is the point I’d like to make. All of these professors and academics at the Fed who never really worked in the private sector a single day in their lives, and write papers nobody reads and nobody’s is interested in. Why would they want not write about how you structure an economic system that lifts the standard of living of most people? You can’t lift everybody.”
“We had that in the 19th century in the U.S. because we had very small government at the time. The entire government — local, state federal — was less than 20% of the economy. Now it is close to 50% of the economy.”
On whether the government is spending too much money:
“The larger the government becomes, the less economic growth you have and the more crony capitalism and corruptions you have. Because big corporations — and especially the money printers, they’re the most powerful people in the world, they control the governments. The U.S. Treasury, the Federal Reserve, and the government is one and the same. The Fed, they finance the Treasury, so the government can go to war in Iraq and Afghanistan. Then they finance transfer payments to essentially buy votes so you can get elected.”
On bitcoin:
“I prefer physical gold and silver, platinum to bitcoin. Bitcoin can have a lot of competition. Gold, silver, platinum — they have no competition. How do you value a bitcoin? I can value gold to some extent and compare say gold to the quantity of money that is floating around the world, to the wealth increase, and to the monetary base increase, to the credit increase, and so forth and so on, and to the production costs. So I have an idea of where gold should be. I’m not sure because prices overshoot. How do you value Netflix? Is it overpriced or underpriced? Is Tesla overpriced, underpriced?”
On interest rates:
“But one thing I wanted to show you and talk about because you said that lower interest rates help people. Well, if money trending helps everybody, then why does not everybody in the whole world always have zero interest rates? And everybody would be rich. You keep on printing money and you don’t need to work here, you don’t need to put on makeup. I could stay in bed the whole day and go drinking in the evenings. So, let’s just print money and be all happy. It doesn’t add up. One thing about the figures you showed: first of all, you live in New York. Do you really think that your cost-of-living increase is a 1.2% per annum? You really believe that? It doesn’t feel like more, it feels like five times more, or even ten times more.”
“Number two, by keeping interest rates at zero percent on the Fed fund rate — i want to emphasize that this is now going on in March of 2014 for five years. It is not something new. For five years this has happened. You penalize the income earners, the savers who save, your parents, why should your parents be forced to speculate in stocks and in real estate and everything under the sun?”
On his view of overvalued stocks, including Facebook:
“I think it is to a large extent a fad. People they go on Facebook – what they do is they put pictures on and the only people that watch these pictures are themselves. They all want to be stars. It is a very distractive kind of occupation. I can’t imagine that this would have a lot of value. I would rather own – I don’t own it because I think it is very highly priced – I would rather own a company like Alibaba or Amazon or Google, than Facebook, personally. This is my view. Other people have different views. That’s what makes the market. Some people are buying it and some people are selling it.”

On overall market valuation concerns:
“I think we are in a gigantic financial asset bubble. But it is interesting that that despite of all the money printing, bond yields didn’t go down. They bottomed out on July 25, 2012 at 1.43% on the 10-years. We went to over 3.0%. We’re now at 2.85% or something thereabout. But we’re up substantially. Now, this hasn’t had an impact on stocks yet. In fact, it pushed money into the stock market out of the bond market. But if the 10-years goes to say 3.5% to 4.0%, then the 30-year goes to close to 5.0%, the mortgage rates go to 6.0%. That will hit the economy very hard.”
“[The bubble] could burst before. It could burst any day. I think we are very stretched. Sentiment figures are very, very bullish. Everybody’s bullish. The reality is they’re very bullish because they think the economy will accelerate on the upside. But my view is very different. The global economy is slowing down, because the global economy’s largely emerging economies nowadays, and there’s no growth in exports in emerging economies, there’s no growth, in the local economies. So, I feel that the valuations are high, the corporate profits have been boosted largely because of the falling interest rates.”

Why the Dollar Dominates, and Why That’s Not All Good

Why the Dollar Dominates, and Why That’s Not All Good

Lack of Rivals to Greenback Keeps It on Top—and Enables U.S. Government Dysfunction

By

DAVID WESSEL

 

Updated Dec. 4, 2013 2:42 p.m. ET

In an interview with WSJ’s David Wessel, Cornell’s Eswar Prasad, author of a forthcoming book, “The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance,” explains why the U.S. currency remains so dominant despite all the nation’s woes.

The U.S. was the epicenter of the worst financial crisis in 75 years. Its central bank is printing money at a rate of $1 trillion a year. Its government debt load is huge and its political system is visibly dysfunctional. It represents a shrinking share of the world economy as China and other emerging markets rise.

You’d think the U.S. dollar’s reign as the world’s supreme currency would be ending—or at least vulnerable.

So now comes economist Eswar Prasad with a surprising argument: “The global financial crisis has strengthened the dollar’s prominence in global finance.”

The dollar, he predicts, will remain the world’s reserve currency for a long time. “When the rest of the world wants safety,” he says, “there is no other place to go.”

Neither the euro nor the Japanese yen is a plausible rival. China’s yuan may be someday, but not soon. China still lacks the legal and other institutions and deep financial markets that make U.S. Treasury debt so attractive to so many.

Mr. Prasad is no flag-waving naif. He’s a University of Chicago Ph.D. who spent 15 years at the International Monetary Fund, where he did a stint as chief of its China desk. He now splits his time between Cornell University and the Brookings Institution.

In a lucid book to be published in February, “The Dollar Trap,” Mr. Prasad argues that the dollar’s persistent dominance is a “suboptimal” reality.

The professor isn’t predicting that the dollar’s value in euros or yen or pounds or yuan will rise inexorably. Like many a card-carrying Ph.D., he sees the size of the U.S. trade deficit and expects the greenback to fall over the long run and eschews predictions about the dollar’s near-term direction.

Mr. Prasad expects China and others to price more of their exports in their own currencies. The yuan recently overtook the euro as the second-most used currency in international trade finance, according to Swift, which runs a major electronic financial pipeline.

But as a safe, secure place to park money, the dollar is stronger than ever. The made-in-America global financial crisis strengthened the dollar’s hold.

Here’s why:

Banks around the world have been ordered by government to hold safe, easy-to-sell assets so they’ll be better equipped for future crises. That adds to demand for government bonds; the U.S. issues more of them than anyone else.

Emerging markets want more safe assets, too. There’s ever-more money sloshing around the globe, much of it moving in and out of emerging markets. That has led them to make two relevant calls:

One, inflows of capital tend to push up exchange rates and threaten exports. So governments are increasingly prone to intervene—that is, to restrain the rise in their currencies by selling them in exchange for foreign currencies. That adds to demand for dollars, which are then invested in U.S. Treasurys.

Two, those same governments have decided it is essential to have a lot of insurance in case foreign capital flees; that means building a big pile of foreign-currency reserves to scare off speculators and to demonstrate they’ve got the money to pay foreign creditors. That, too, adds to the demand for dollars and U.S. Treasurys.

This demand is occurring at a time when safe assets are in short supply: The Federal Reserve has taken $2.2 trillion of U.S. Treasurys off the market through its bond-buying program. The euro has its issues, and the sovereign debt of some euro-zone members is hardly ultrasafe. Japan and Switzerland have strong institutions and financial markets, but are actively pushing down the value of their currencies; that makes them unappealing as stores of value.

“The entire edifice of global financial stability seems to be built on this fragile foundation: If not the dollar, and if not U.S. Treasury debt, then what?” Mr. Prasad writes.

So what makes this “suboptimal”?

For the U.S., Mr. Prasad says, the global appetite for dollars keeps U.S. interest rates low and makes it easier for the U.S. to pursue foolish budget policies aimed at too much deficit reduction now and too little later.

For other countries, the world’s heavy reliance on dollars makes nearly every economy acutely sensitive to moves (or expectations of moves) by the Fed to increase or decrease the supply of dollars as it tries to steer the U.S. economy. And their stockpiles of dollars exposes them to losses if the dollar’s value declines, which gives them a reason not to do anything to harm the dollar.

The more angst in the world, the more investors and governments want to hold dollars. This makes the dollar’s dominance “stable and self-reinforcing,” Mr. Prasad concludes.

If the dollar’s role isn’t sturdy—if it is more like a sand pile just a few grains away from collapse—then the world is in trouble. Despite years of yammering, the world hasn’t built an alternative to the U.S. dollar.

Write to David Wessel at capital@wsj.com

A Global Boom Is Facing the End of Easy Lending

New York Times

August 20, 2013

A Global Boom Is Facing the End of Easy Lending

By LANDON THOMAS Jr.

In a city where skyscrapers sprout like weeds, none grew as high as the Sapphire tower in Istanbul.

Today, it stands as a symbol of how far the mighty may fall.

Like a vast majority of new buildings that have blanketed the Istanbul hills in recent years, the Sapphire — at 856 feet it is the tallest in Turkey and among the loftiest in Europe — was built on the back of cheap loans, in dollars, that have flooded Turkey and other fast-growing markets like Brazil, India and South Korea. The money began to flow when the Federal Reserve and other major central banks cut interest rates to the bone in 2009 and cranked up the printing presses in a bid to spur recovery in the United States and other advanced industrial nations.

But now, with expectations mounting that the Federal Reserve, led by its departing chairman Ben S. Bernanke, may soon begin to tighten its monetary spigot, Istanbul’s skyline could well be a harbinger of an emerging-market bust brought on by unpaid loans, weakening currencies, and, eventually, the possible failure of developers and banks.

This week, stocks and currencies in several developing Asian markets, including India, Indonesia and Thailand, have been hit hard. Global investors continued to withdraw funds from emerging markets, as interest rates edge up in anticipation of the Fed’s move to reduce its stimulus efforts in the United States. Indonesia’s benchmark index, which fell 5 percent on Monday, dropped 3.2 percent more on Tuesday. India’s stock market fell 0.3 percent after sliding 5.6 percent in the previous two trading sessions.

Some analysts see it as the markets reacting to an end — real or perceived — of the Bernanke boom. “What we are witnessing is a huge bubble, a Bernanke bubble if you will,” said Tim Lee of Pi Economics, an independent consultancy based in Greenwich, Conn.

Not everybody is as alarmed as Mr. Lee. Still, 16 years after emerging markets in Asia imploded after local currencies collapsed, even optimists are starting to grow nervous over the rapid accumulation of dollar-denominated debt not just in Turkey but in other now-struggling economies like Brazil, India and South Korea.

As it turned out, some of the biggest beneficiaries of the Fed’s largess were not so much in the developed world, but among the politically connected elite in emerging nations like Turkey, where vanity towers, glitzy shopping malls and even grander projects to come — a third bridge across the Bosporus and a vast new airport — have become representative of the nation’s new dynamism, economic as well as geopolitical.

What these elites have so far ignored, Mr. Lee warns, is that their obligations carry with them a significant and pressing danger: currency risk.

Unlike the risky loans made to subprime borrowers in the United States or Irish real estate developers in the euro zone, dollar debts taken on by companies erecting skyscrapers in Istanbul, manufacturing steel in India and prospecting for oil in Brazil, need to be largely paid back in dollars by entities that earn most of their revenues in their home currency.

When the Turkish lira or the rupee in India was strong — as these currencies were until recently — local companies had every incentive to borrow in dollars at comparatively lower interest rates.

But when local currencies start to weaken, in line with diminished economic prospects, then the effect is twofold: paying off dollar loans becomes more costly for the borrower, and the lender becomes increasingly skittish about his exposure to a fragile currency and may move to reduce or even slash credit lines.

While Brazil has the largest amount of dollar loans outstanding at $287 billion, few countries have relied on this source of money as much as Turkey, where dollar loans of around $172 billion represent 22 percent of the overall economy.

In recent months, the Turkish lira has lost 4.5 percent of its value against the dollar. Adding to this, protests have hit Istanbul’s main public square over an unpopular building sponsored by a developer with close political and cultural ties to the prime minister, Recep Tayyip Erdogan.

Goldman Sachs is forecasting a dollar-lira rate of 2.2, representing a 15 percent mini-devaluation from the current level of 1.95. “The Turkish economic miracle was built on liquidity and a massive appreciation of the Turkish lira,” said Atilla Yesilada, an economist at Global Source partners in Istanbul, who has lived through Turkey’s previous financial crashes in 1994 and 2001.

These loans — many of them relatively short term — also highlight a recurring characteristic of the emerging-market growth boom: the powerful nexus between ambitious governments eager to promote high-profile investments and politically connected business groups ready to take on such projects.

The Sapphire tower in Turkey is a perfect example in this regard.

The 54-floor tower, which received a ceremonial baptism from Prime Minister Erdogan when it opened in early 2011, is the signature property of the Kiler Group, one of the many construction-themed conglomerates that have achieved extraordinary success since Mr. Erdogan came to power in 2003. Like Mr. Erdogan, whose family comes from the northern Black Sea region, these businessmen hail from Turkey’s conservative Islamist provinces.

According to regulatory filings, 154 million liras of the group’s total 164 million liras in debt is denominated in dollars — about $79 million using current exchange rates. Of that figure, $25 million is related to the Sapphire tower, company officials say. Most of the group’s debt is short term, and in a reflection of the project’s risk, regulatory documents show that the cash generated by the property goes directly to the project’s primary creditor, Akbank, the fourth-largest bank in Turkey.

Given the differential between dollar loans at 6.5 percent and lira credit costing 11.5 percent, it was no surprise that the Kiler Group and others chose to borrow in dollars. The company, in its most recent filings, acknowledged this risk: if the American dollar gains 10 percent against the Turkish currency, the loss to the company would be 11.8 million Turkish liras.

According to Rasim Kaan Aytogu, chief financial officer for the Kiler Group, the Sapphire tower’s share of that total is $25 million. He contends that because the project books its revenue in dollars it is not exposed to currency fluctuations. He also says that demand for apartment units is strong, with 66 percent of them sold.

“This is a unique property in all of Europe,” he said. “And it is becoming a travel destination.”

But Turkish real estate experts say that sales of the apartments, which cost from $1 million to $10 million, have lagged and that the tower does not have the prestige of rival properties, including towers built by Trump and Zorlu. And according to company filings, revenue from visitors ogling the view from the tower’s observation deck have undershot targets from the outset.

The Kilers are not alone in their ability to make a big splash in Istanbul by deploying dollar debt and political muscle.

Even more influential has been the Kalyon Group, another real estate conglomerate with close ties to Mr. Erdogan. Kalyon is the main developer behind Mr. Erdogan’s controversial effort to build a replica of Ottoman-era army barracks as a shopping mall near Taksim Square.

As troubles were beginning to brew in Turkey, the leader of the Kalyon Group, Cemal Kalyoncu, remained confident that nothing would change. Asked in an interview with a local paper how the consortium of companies that won the tender for the airport would obtain the money, Mr. Kalyoncu said the group would look for loans outside Turkey.

“Financing this should be no problem at all,” he said.

Companies Shift Cash Out of Treasurys as Fears Subside

August 7, 2013, 1:28 PM ET

Companies Shift Cash Out of Treasurys as Fears Subside

Companies moved money out of government debt and into commercial paper and corporate debt, as worries over Federal Reserve policy faded and treasurers showed a willingness to take on some risk to gain yield.

Click on the image above to view an interactive chart of corporate cash allocations.

U.S. Treasurys ended a three-month streak of increases in their share of corporate cash allocations, falling by 0.85 percentage point to represent 26.5% of corporate cash on August 1, according to data from Clearwater Analytics.

Corporate debt and commercial paper grew by .55 and .32 percentage point, respectively. Corporate debt remains the largest asset class among cash allocations, representing one-third of the total.

Worries that the Fed would reduce its bond-buying program prompted credit spreads to widen in May and June, said Rhet Hulbert, a portfolio manager at Clearwater Advisors LLC. But last month, he said, “the market settled, recognizing an over-reaction.”

Mortage-backed securities grew by .21 percentage point to 3.5% of all cash allocations.

“Mortgages had been underperforming other asset classes recently,” Mr. Hulbert said, “but investors in July moderated their views on risk and interest rates and moved some assets back into the space.”

Other asset types were mostly stable last month. Both agency bonds and CDs sank by 0.16 percentage point, but all other asset classes shifted less than 0.1 percentage point in July.

The 3 Ms of Risk Management

The 3 Ms of Risk Management

 

 

 

Recent market event have pointed to increasing volatility. As has happened all too many times in the past, risk management disasters continue to plague the industry and show up on the front page of the newspapers. Given the potential for these disasters to occur, lets discuss some required risk management capabilities.

 

Consider the following scenarios:

 

A major market move occurs. The Chief Risk Officer (“CRO”) of a broker/dealer wants to know right now what effect this has on the firm. Are they better or worse off? What actions should be taken? To determine the best course of action the CRO needs to know real-time what the positions are and the potential P&L effect. The CRO must also be able to perform a risk analysis immediately. As we have seen, inability to do this will consume resources, raise the firm’s risk profile and possibly cause losses as a result of the market move.

 

A major firm announces a significant profit restatement. The CRO of a major retail brokerage wants to know which accounts will be affected the most. The CRO needs to know real-time which accounts have concentrations in that industry and SIC code. Since it isn’t clear yet what the full effect of the restatement will be on security prices, can the CRO perform a what-if analysis on specific accounts to determine the potential effects on the firm and the accounts so that proper actions can be taken? Inability to do this real-time will consume resources and increase the risk profile of the firm and the accounts.

 

In both cases, could the CRO have set up early warnings so that the risk systems would have generated alerts as to problem positions or accounts when specific actions occur so that the CRO can spend less time finding risks and more time managing risks?

 

The industry has spent many dollars effecting comprehensive risk management capabilities. Ultimately risk management is, however, a process that requires tools and the right mindset, not just a system that measures risk. The purpose of risk management is the following: minimize the probability that an error occurs AND that it goes unnoticed. To do that, a firm must have all the components of effective risk management. The firm must have the ability to perform the 3 Ms of Risk Management: Measurement, Monitoring and Management of risk. In this paper, we will outline the basic capabilities of each of the three areas.

 

 

Risk Measurement

 

All firms must have the capability to measure their risks. Most firms have risk measurement systems. However, there is a lot more to it than that. Risk measurement involves ALL aspects of the capability to measure risk, not just having systems. To measure risk effectively and accurately, the firm must have accurate and timely information as to its positions, its counterparties and all relevant information regarding its positions and counterparties. This information should ideally be available on a real-time basis as markets move very rapidly and soon the risk analysis may no longer be valid. Measuring this information solely on an overnight (or end of day) basis will not be sufficient as market conditions change during the day, and customer and counterparty activity changes the firm’s risk profile constantly. It is also not sufficient to simply do this several times a day. As market conditions change, the value of the firm’s and its customers’ positions changes accordingly, either favorably or unfavorably. In addition, as customers do trades during the day the firm must be able to track its customers’ accounts as they transact business. This information must be accurate, accessible in a timely manner and able to be retrieved from the firm’s computers and sent to the relevant analytical models for risk evaluation. During some recent risk events, many firms learned that they could not do this effectively, much to their dismay.

 

So what does effective risk measurement entail? Several key components are required:

 

The risk measurement methodologies used must accurately measure the risks. There are many different ways to measure risks and firms use most of them. The two basic necessities for a risk measurement methodology to be effective are that they must reflect the risks they measure and all relevant parties must understand them.

 

Different kinds of firms will require different kinds of risk measures. The measures needed for a portfolio-based approach to risk measurement are not exactly the ones needed for a retail operation. The portfolio approach requires position, position attribute, counterparty and counterparty attribute data. A retail operation will require all that and extensive information at the account level so it can see what individual accounts are doing real-time.

 

The firm must be able to examine its risks at any level and aggregate up or drill down to any desired degree. For example, a broker dealer must be able to measure risk by security, security type, counterparty and type, industry or SIC classification, currency, geographical location, etc. The B/D should then be able to aggregate up or drill down in any direction (for example by country by currency or vice versa). A retail brokerage should be able to measure risk by account, by account type, by industry, SIC code, etc, and aggregate up. They should also be able to drill down to the account level after starting with a portfolio approach. In addition, a retail brokerage needs to perform sophisticated margin calculations on a wide variety of products. Also, they would need to be alerted when specific activities occur in selected accounts, e.g., large trades or prohibited activities.

 

The firm must be able to perform scenario and what if analysis on a real time basis for any of its risk measurement categories. For a retail operation, this means even at the account level.

 

The analytical models used to measure risk must be accurate and measure the right risks. The models must be appropriate to the business and the products. Different products may require different kinds of models and there is nothing wrong with that. Use as many models as is necessary and no more.

The inputs to the models must be accurate. Many firms have a problem with their data and getting it to the right system at the right time. The data must be accurate, clean, and timely. This applies to model-generated data (including the results of risk analysis) as well as historical market data. Without accurate inputs, the model will give misleading results, leading to inaccurate decision-making.

 

The connections between the systems must be accurate. Feeder systems must feed the inputs to the risk model on a timely and accurate basis, just as the risk system must feed other systems in the same manner.

 

The systems must work automatically. You should not have to do anything extra for the system to be measuring risk accurately and timely.

 

The firm should periodically assess its systems and their ability to perform, effecting updated capabilities when necessary.

 

 

Risk Monitoring

 

For effective risk management to take place, risks must be monitored. A firm that simply measures risk three thousand ways but does not monitor it on a timely basis will likely suffer at some point. Risk monitoring includes all aspects of ensuring that accurate risk measurement information is available to the right people on a timely and accurate basis. What does effective risk monitoring entail? Several key capabilities are required.

 

The firm must have timely and accurate risk information available to the right people at the right time.

The firm must have a set of comprehensive risk reports generated during the day. The reason that a set of reports is necessary is that different levels of management require different levels of risk information. The key criterion is that the reports reflect the degree of granularity and breadth of information required to optimize the decision-making capabilities of the party that gets the reports.

The firm must also have this information available on a real-time basis. This means that it must be available online for the parties that require it so they can see what is going on at all times. The same issues of granularity and breadth apply here.

 

The risk systems should have the capability to alert the proper manager when preset conditions occur so that proactive risk management can occur. The firm should set up a variety (as many as needed) of risk conditions that different managers are concerned with. These conditions should also be set in a variety of ways. The parties could set up criteria that will generate alerts. The relevant manager could then drill down into the alert to investigate further. The proper action could be taken.

For example, a B/D could set these alerts to show limit utilization above a certain level (e.g., 75%) and by security, currency, counterparty, trading ledger, industry or geographic location. The system alerts the appropriate level(s) of management when the condition is met. The alerts should also happen as a result of a what-if or scenario analysis, alerting the appropriate party to what could happen under certain conditions. For example, an alert could occur if a major market move would cause an X% loss in a particular security. Management can then examine the alert and take appropriate action, if any. These alerts are set by management and should reflect the conditions with which management is currently concerned.

For a retail operation, this would include all the above. It would also need to include alerts at the account level such as a big trade or an account that is utilizing an increasing portion of its credit and is heading toward a potential margin call. For example, an alert could occur if an X% market move would cause a margin call in a large (or small) account(s). Management can set up appropriate conditions for accounts it wishes to monitor and be alerted when those conditions are met. Management can then examine further and take the appropriate action, if any.

In addition to all the reports and alerts, managers must effectively communicate with each other so that they are aware of current conditions.

 

 

Risk Management

 

The first two steps in the process provide the analytics and the tools that managers at all levels must have in order to make effective decisions regarding risks. The final step in the process may be the simplest to explain. After all the risks that can be measured are monitored (those that can be measured. Not all risks can be measured and you should not try!), and after the correct monitoring systems and procedures are in place, the final step in the process is actually managing the risk. This simply means management decision-making when called for, based on the information that is available. Managers at every level must be ready to take appropriate actions when a condition exists that warrants attention. This means proactive actions. Remember that not every risk condition or situation requires action. It possible that, for example, that a limit is exceeded on a trading floor and management becomes aware of it. After reviewing the excess, determining the cause and discussing the possible harm, the appropriate managers may let it stand and take no action. Or, an alert can be generated on a specific account. After drill down and review, management decides no action is called for.

 

Some of the critical aspects of managing risk effectively are:

 

The proper analytical tools must be used so that the information to decide possible courses of action is reliable

The proper risk monitoring capabilities, including alerting capabilities that provide this information on a real time basis, must be in place

A risk-oriented mindset must exist in all employees. Senior management must drive this mindset from the top down. Everyone bears some of the responsibility, not just management and risk managers

A willingness to be proactive regarding risk management, treating risk management as a business partner, not simply part of a compliance function

 

Conclusion

 

As we all know, there are many crucial aspects to implementing effective risk management capabilities at a firm. It is critical that each phase be implemented at any firm that wishes to effectively manage its risks. This can be summarized relatively simply. The tools for measuring risk must be accurate as must be the inputs to those tools. This means models must be accurate. Data must be clean. The technology behind the system should help the risk management process by identifying risk so that managers gave increased resources for managing risks. Real-time capability is required; batch processes won’t cut it any more. The outputs of the risk measurement process must be available on a real time basis so that managers understand what is happening as it is happening and can take appropriate action. This means everyone gets the info when they need it. Systems that inform management of current conditions go a long way to helping the process. Finally, everyone should consider risk management as part of his or her job. Effective risk management is possible when these conditions are met.

 

 

New FX Volatility Likely (Stay Tuned)

Some Comments on Recent Exchange Rate Activity 

The FX markets are critical to smooth functioning markets. Sooner or later EVERY piece of international trade will involve a foreign exchange transaction. That is one reason the FX market is by far the largest market in the world. Another factor is the amount of currency speculation that occurs. Here we simply have those buying and selling solely to try to benefit from anticipated price movement. Finally we have hedging activities, those taking offsetting positions to reduce the overall volatility in a firm or trader’s P&L. These are just some of the factors that affect the FX market, which includes currencies and derivatives.

Some recent actions point to the possibility of increasing exchange rate volatility in the near future.

  1. Japan has recently begun a change in their macroeconomic management of the Japanese economy. Their desire to cure the deflation which has been hurting the Japanese economy is likely to cause an increase in the inflation rate. This can cause a weakening of the Yen relative to other currencies
  2.  Thailand is considering capital controls and interest rate actions to cool the rise in the Baht
  3. The US has had very low interest rates for several years as the Fed has been trying to manage the economy back to health. At some point interest rates in the US are likely to rise from their current levels. This will likely cause some increase in exchange rate volatility.
  4. Problems with the Euro have been plaguing the world, although based on member country interest rates, it appears that markets have calmed down a great deal

While many factors affect currency markets, here is a quick overview of three key relationships affecting exchange rates. We are describing each factor independently even though they are interactive and NOT the only factors affecting exchange rates.

  1. Interest rate differentials between two countries can affect exchange rates by making investments in the higher interest rate country relatively attractive. This comes from two potential sources. First, the higher interest rate can potentially offer a more attractive rate of return. Second, if the rate is believed to be ‘high’ and likely to come down, there will be a potential capital gain earned should rates decrease. This can translate into an enhanced rate of return for the investor.
  2. Inflation rate differentials can affect exchange rate by causing a devaluing of one currency relative to another. Generally speaking, the exchange rate between two currencies will depreciate relative to the difference in the inflation rates between the currencies. Inflation tends to weaken a currency and so we could expect the inflation rate differentials to drive a wedge into the exchange rate
  3. The Fischer effect (named after Irving Fisher) states the nominal rate of interest is related to the sum of the real rate of interest and the expected inflation rate (while this is not literally the relationship, it is close enough for what we are discussing here). As inflation rates rise nominal interest rates should tend to rise with them, although there is often a time lag. If inflation rates rise (as some think likely) expect nominal rates to rise.

In general, an increase in the level of rates tends to raise the measured volatility of those rates. In other words, volatility tends to be higher as the LEVEL of rates gets higher. So if rates go up in the near future (for any reason – inflation, commodity prices, etc) we can expect a corresponding increase in exchange rate volatility.