Understanding the Forex Market

This article aims to understand the forex market better. We are going to deepen our knowledge looking at two of the most important characteristics for a professional portfolio manager: volatility and correlation.  
Through this article, we aim to clarify which currency, if any, could be useful in order to increase the diversification of our portfolio. Understanding the aforementioned behaviour it is extremely important both for hedging and speculative purposes.        
It is possible to recognize two different bundles of currencies, looking worldwide at the investment opportunities: developed and developing markets.

DEVELOPED MARKETS

There is no a perfect definition of developed country, especially in the last period of exceptional monetary policy and lack of inflation. According to Investopedia and other reliable sources, the word “developed economy” typically refers to a country with a relatively high level of economic growth and security. Some criteria for evaluating a country’s degree of development are per capita income, GDP, level of industrialization and others general standard of living. For this article, we used weekly data from 7th January 2001 to date for the following developed currency related to the US Dollar: 

  • EUR (Euro)                                  

  • JPY(JapanYen)

  • GBP (Great Britain Pound)     

  • AUD(Aussie Dollar)

    
The following chart shows the rolling correlation between the aforementioned currencies and the S&P500, which we are going to consider as the proxy for the stocks market worldwide.
It is interesting to notice that the Euro (blue), the GB pound (grey) and the Australian Dollar (yellow) tend to follow the same path from 2001 to date. These three currencies show a slightly positive correlation with the

 

stock market, while during the financial crisis they tend to increase their correlation with the S&P500.    
What does it mean?     
Personally, we believe it has been the normal consequence of the US dollar depreciation. In that period, the Federal Reserve responded to the crisis saving the financial system and introducing the nowadays-famous Quantitative Easing program. The huge amount of money in the market and the mistrust towards the US economy played a fundamental role for the US depreciation and the beginning of the stock market rally. The positive correlation is just a consequence of these two effects.        
The Japanese Yen instead tends to have a negative correlation with the stock market and the Japanese economy both bond and stock markets could be an important source for a fund manager looking for diversification.  
The first chart in the following represents the volatility of each currency. From above it is possible to see how it changed from 2001 to date thank to the risk metrics approach adopted for assessing the risk in the financial markets from JPMorgan first.

 

It is easy to see that the Australian dollar is, on average, the riskiest among the developed currencies. Since its correlation tends to one and its variance tends to increase especially in period of crisis it is not a good mean of diversification for building a well-diversified portfolio. Vice versa, the volatility analysis confirms that the Japanese Yen, although it is the riskiest currency lastly, it tends to help in diversifying the portfolio.

DEVELOPING MARKET          

A developing economy could be defined as an economy that has some characteristics of a developed market, but does not meet standards to be a developed market. According to some economists, a developing economy displays the following characteristics:

  • Intermediate per capita income

  • Volatile growth level

  • Institutional transformation   

For understanding the behaviour of the developing currencies we utilize monthly data from the 2001 for the following economies:

  • INR (Indian rupee)                

  • BRL (Brazilian Real)

  • ZAR (South African Rand)    

  • CNY (Chinese Yuan)

  • RUB (Russian Ruble)

It is important to notice that while the developed currencies have been expressed as:  “how many X I need to buy one US Dollar”; the developing currencies instead are: “how many US Dollar I need to buy one unit of X”.  

      
Looking at the correlation in the graph above it is clear that after the crisis all the developing currencies tends to have a negative correlation with the S&P500. It means that when the stock market goes up the currency goes down. Let us make an example. The red line represents the Brazilian real, as you can see, it tends to have a negative correlation with the stock market.
It is interesting to see that just before the financial crisis of the 2008 the Chinese Yuan worked perfectly in diversifying a portfolio.

The volatility analysis is more interesting for the developing market than it was for the developed one. 

The Chinese Yuan shows a very low volatility, it is due to the flows control of the Chinese government, which is going to reduce in the future in order to complete the transaction to a market economy. In the last month, the Yuan has been included in the bundle of the IMF.                    
Following the Oil crisis, we can see that economies depending on Oil shows higher volatility than economies importing Oil. As a result, it is possible to spot an increasing volatility for the Russian Ruble, the Brazilian Real (more due to economic crisis than Oil) and the South African Rand. On the opposite side the Indian economy, which is a net importer tend to reduce its volatility in the last month.    
Seeking Investment opportunities that could provide the best risk adjusted return I would suggest the 10Yr Indian Government Bond, which guarantees 7.2% of return yearly.
In addition to this the currency risk seems to be moderate thanks to a good growth in India and the position of this economy related to the Oil.

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