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Effective FX

Traditional asset managers make use of the foreign exchange market to hedge their clients’ risk exposures. But the current macro-economic and political environment is producing interesting investment opportunities in the FX space, explains Vassilis Papaioannou, Dolfin’s chief investment officer

19 May 2017 / Investing

Hedging the FX risk of investing in foreign currency-denominated equities, bonds and other instruments makes sense. This is prudent, and we do so at Dolfin as a matter of course. But we also take the view that investors should allocate some space in their alternatives portfolio for FX strategies. The question is, how do we do that? How can we analyse the opportunities? How can we safely exploit FX investment ideas and themes?

Two models and the macro view

Fundamental FX analysis uses different models (purchase price parity, interest parity, or balance of payments) to examine currency values and future movement. You can also look at differences in price levels, interest rates, inflation and, based on these differentials, make assumptions of where a spot rate should trade versus where it is actually trading.

Then there is the quantitative or technical approach. This uses quantitative data and technical analysis to deliver forward looking guidance from trend data or from a momentum point of view. Trends are backward-looking; momentum takes a more forward looking approach.

Volatility produces trading opportunities.

We use both of these models, and then bring in the global macro view. We look at what is currently happening in the political arena: what the political developments are – such as Brexit in relation to the British pound, or Trump and his policies in relation to the dollar – and other significant events. We look at emerging markets as well as developed ones, because these are also heavily dependent on global political actions and events.

Anyone who has observed the political scene over the last year will quickly recognise how macro events have caused turmoil and volatility in financial markets – and volatility produces trading opportunities. Most asset managers have a small allocation in their portfolio for alternatives such as real estate, hedge funds, and more or less any other investment that is uncorrelated with the traditional asset classes. At Dolfin, we add directional FX strategies to these.

From Tokyo to Trump’s wall

The Japanese yen is the world’s third most traded currency after the dollar and the euro. We entered the trade last August at 100. Following the US election, the ‘Trump effect” caused the currency to rise to 118 in December. We saw an 18 per cent profit within five months, and it is It is now trading at 109. Political factors contributed, as did Japanese exports, which were around 10 per cent down year-on-year, with a significant impact on exporters’ profitability.

We took the view that the yen would have to weaken in order to protect the competitiveness of the country’s exports. We monitored its price and waited for the market to validate our view. Last summer, the currency broke out of its long-term upward trend, so it was the right time for us to short it, which we did using yen futures.

Another of our ideas concerned the Mexican peso. Since the start of the US election, it had been traded as a fear proxy and had become undervalued, but Mexico’s economy has size and strength and its economic fundamentals were not aligned with the level of its currency.

The big question was what the Trump administration’s policy towards Mexico would actually be. We monitored events and saw senior US officials speaking about their objectives regarding Mexico in much softer tones than the President’s aggressive rhetoric during his campaign. This started to be reflected by steady peso buying in the market and an upward move in price.

Harnessing the FX market can present interesting investment opportunities.

Consequently, we took a position in the peso by buying futures and short-dated Mexican Government peso bonds. We profited as the currency appreciated against the dollar. This is an example of how we used an FX-directional idea to enhance alternatives portfolio returns.

In summary, FX is part of our daily lives. We believe that harnessing the FX market can present interesting investment opportunities, so we use our research capabilities to analyse these and share the results with our clients and business partners. We are clear and concise about our research process, explaining how we come up with trade ideas and how we know how to implement them. In this way, we not only reduce currency risk in a portfolio but use FX to enhance profitability.

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Founded as a London-based wealth boutique in 2013, today we’re a diversified financial services firm with an international presence and our own bespoke technology platform.

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