Investors are increasingly impatient and there is a rapidly growing demand for equity capital that has to be pumped into the economy to salvage balance sheets. Governments and central banks are already fully leveraged and do not have sufficient resources to keep interest rates low indefinitely. Fixed income markets around the world will unravel; this will send shock waves across the global economy.
Today, there are globally 212 trillion USD of financial assets, which includes 158 trillion of debt, see the 2011 McKinsey Global Institute report. The debt is 3.5 times bigger than the world annual product of 45 trillion.

As soon as interest rates start to increase, then the prices of bonds drop. The economic impact of the price decline will be daunting due the sheer size of the 158 trillion of outstanding debt…

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By: Richard B. Olsen, Founder and CEO of Olsen Ltd

In October, the unfolding of the European crisis was in the focus of market participants. At the European summit a new rescue package for Greece was structured. Governments and private institutions have decided on a haircut for the Greek debt. After the US has enacted the Volcker rule for banks, European banks will have to recapitalize by 106bn EUR and increase their core capital quota to nine percent.

Product profile AF generated 1.18% net profit. The high market volatility in October offered profitable trading opportunities in many of the currencies, in particular CHF, CAD and EUR.

To learn more about our managed accounts please visit Olsen Invest.

Olsen proposes the introduction of electronic certificates, global early warning system or stabilizing investment strategies, among other innovations. He also gives us his forecast on the market volume and turnover, diversity of market players, investment products, ethic changes or technology and internet evolutions. “Long-term, there will be one centralized exchange – it will be embedded and integral part of the Internet” he foreshadows.

BIS survey reports that spot volume is 1.5 trillion per day in Forex. Are currency markets really as liquid as BIS surveys imply?

Richard Olsen: No, they are not. To the contrary. The actual spot volume of 1.5 trillion per day translates into a small transaction volume of only 17 Mio USD per second. On average there is only 8.5 Mio USD buying and 8.5 Mio selling volume. If an order of 100 Mio USD is triggered, then this order will dominate the market for 10seconds and more. So relatively small market orders of 100 Mio USD or even less can trigger powerful price moves, which can bring about margin calls that amplify the imbalance of buyers and sellers pushing the price even further.

Will transactions turnover increase or decrease in the future?

RO: In the very long-term volumes in the foreign exchange markets will increase massively with the success of quantitative trading strategies that gain wider acceptance. Short-term, I expect volumes to decline, because of the increased uncertainty due to the economic crisis.

In this economic crisis context, some central banks decide to inject money in the market. What effect do these interventions have on the functioning of markets?

RO: The recent interventions of the SNB and BOJ stabilize markets in the short-term, but increase volatility in the long-term. The interventions of the central banks skew the perceptions of market participants. Market participants rely on central banks to continue to intervene; this skews the balance of buyers and sellers. As SNB and BOJ continue to intervene, more and more traders go short, CHF and JPY. When ultimately the price level breaks, the selling volume of margin calls is far larger than would have been the case otherwise increasing the size of the adverse price movement.

Will the market maker’s model be modified in the future?

RO: In recent years, we have observed that the Internet is rapidly mutating from a pure information network into a global market place. I expect that this development will accelerate and that the Internet itself will turn into one large exchange.

My long-term expectation is that traders will trade electronic certificates, a virtual representation of the underlying financial asset, directly on the Internet exchange. We are not yet there, but this is the major development that will take place.
In one respect the Internet exchange will function differently to other organized exchanges: the ranking of bid/ask limit orders will be done on the basis of the size of the respective spread, not the best bid or ask. This change is important, because the direct access with a ranking system based on best bid/ask gives rise to a price instability, which high frequency traders take advantage of.

Do you expect diversity in the types of market players (besides liquidity players, commercial and speculators) to increase in the future?

RO: Yes. In the recent past, we have observed a rapid increase of the number of retail traders; only 10 years ago, this group was quasi non-existent. Today, retail trader account for up to 10 percent of global volume. Corporations do hardly any foreign exchange trading, only the absolute minimum, this will change, when they become aware of the true cost of their passive strategy and the benefits of dynamic hedging. Going forward there will be a lot of growth in volume and diversity of market participants.

What kind of trading strategy should be developed based on this scenario of volume and market participants increase?

RO: Our trading algorithms take advantage of the diversity of trader profiles: our models measure the degree of imbalance between the different groups and identify trading opportunities, when the groups get out of line with each other and there is a large disequilibrium. We take advantage of the disequilibrium to take counter-trend positions i.e. we push back when markets overreact. In doing so, we contribute to market stability. We take advantage of the ongoing up and down move of the market to gradually improve the price average of our positions and then close out the position, when we have reached our profit objective.

What is your assessment of today’s financial system structure?

RO: My assessment might sound too negative; the global financial system has gone beyond the point of no return. The sovereign debt crisis, which has inflicted Iceland, Ireland, Greece and Italy will spread to other countries, not just at the outer frontiers of globalization. The crisis cannot be averted. Refinancing rates will go through the roof, Central banks are highly leveraged and do not have the necessary firing power to avert the real crisis, when the global economy starts to slow in earnest and investors panic. There will be a meltdown.
The global economic system is dysfunctional because of the mismatch between the modern technology used in the real economy and the operational procedures of the financial system, where there is no ongoing settlement and the whole system is batch based. The financial system needs to be reformed, which is not as difficult as people might think.

Your view of the current system is negative, but there is still hope then…

RO: There is not just one thing that needs to be done to make the world safer and more robust. Reforms at several different levels are necessary. If we go for partial solutions, then things can even get worse.

What reforms would make financial structure works better and more safely?

RO: We need to embrace new ideas. We have to streamline the back office operations and move to instantaneous settlement with second by second interest rate payments. In a financial system, where 80% of the trades have a duration of less than 20 minutes, second by second interest rate payments are more than a technical detail.
For instantaneous settlement to happen, we need to introduce electronic certificates, which make any asset easily transferable. The electronic certificates will be issued by the equivalent of notaries for property of land.

We also need to launch a global early warning system, which is organized along the same lines as Wikipedia. It will collect digital data of the real economy and financial markets from sources from around the world to generate online forecast and risk information. I envisage system like a huge economic weather forecasting service covering all aspects of our economy.

In the world economy, should investment strategies be changed? In which way?

RO: We have to stabilize investment strategies: few people are aware that the buy and hold strategies that are recommended for all types of investors and the trend following strategies destabilize the financial system. The global economy is a complex system, which can only achieve stability, if financial assets are managed by market stabilizing investment strategies. Central banks and sovereign wealth funds should use their collateral to trade counter-trend investment strategies and counter-act market excesses. I am not saying that central banks should target particular price levels, they should target a particular volatility regime and take positions, whenever volatility increases and prices overshoot.

Any reform regarding the investment products for the retail traders?

RO: There is a need to develop user friendly investment products. I very much believe in creating the equivalent of an iPhone for investment products – the products need to be designed in such a way that they are intuitive and user friendly; embedded in the financial products should be all the heavy lifting of intra-day decision taking and should be designed in such a way that they contribute to market stability.

Will analysts and traders be dependent on sophisticated technology to achieve absolute returns, or will basic tenets of technical analysis be preserved?

RO: Practitioners developed technical analysis because the economists were not able to provide them the appropriate tools. This is changing. Finance has made a lot of progress and is gradually making available to the everyday man useful decision support tools that significantly improve the performance of retail traders.

Many citizens are criticizing the lack of ethic of the traders and financial markets… Do you agree?

RO: The insiders of financial markets know the inner working of the financial system and can use this knowledge for their own personal benefit, but at the expense of the society at large.

Insider manipulation is prejudicial and illegal. Do you think financial markets actors should be given a stronger sense of responsibility?

RO: In medicine doctors have to swear the Hippocratic oath and are not allowed to abuse their power, we have to create awareness that all aspects of business have an ethical component, where we need to do the right thing: we are not allowed to embark on an action if it only benefits ourselves at the expense of the group at large or the whole society. We are only allowed to take actions that are also beneficial for society as a whole.

To conclude, Richard: are you bearish or bullish as for the future of the markets?

RO: I could not be more bearish for the next two years. There are, however, solutions and we can turn things around. We need to have the courage for change.

(Source: fxstreet.com)

Currency risk is incurred, whenever assets or liabilities are denominated in a foreign currency.  Liabilities are the opposite of assets and can basically be hedged in the same way as assets. Assets, just as liabilities, can be of any shape or form; they can be financial instruments, fixed assets, such as a house or factory; or an income or payment stream, for example pension receipts or payments for project work. Whenever the foreign currency appreciates, the value of the respective asset increases, whenever the foreign currency drops, so does the value of the asset. Any rise or decline in value of an asset represents volatility and is an incremental contribution to risk. Investors can improve risk adjusted performance, if they can lower risk without reducing return expectations.

The price movements in the currency markets are an important risk factor for assets and liabilities denominated in foreign currency. Currency movements of plus or minus 10 percent in 6 to 12 months are nothing extraordinary. Occasionally currency movements are far bigger and may move by plus or minus 30 percent in only six months. This explains, why in principle there is a lot of interest in neutralizing currency risk through hedging or currency overlay, as professionals call it. There are the following methodologies to hedge currency risk.

Static hedge

The institution hedges its currency exposure by selling the equivalent amount of foreign currency and buying the home currency. The selling of the foreign and buying of the home currency occurs at the exchange rate that is quoted at the time of executing the hedge trade. As long as the hedge stays open, the institution has to pay credit interest on the foreign currency and receives the debit interest on the home currency.

The operational details of the static hedge are the following: it is necessary to setup an account to execute the currency hedge.  This involves putting up collateral to fund the hedge. The collateral is the margin capital to fund the hedge and absorb potential losses during the lifetime of the hedge. The collateral is typically roughly 10 percent of the value of the foreign asset. The collateral is used as margin capital for the actual hedge and to offset losses, in case the foreign currency appreciates and the hedge is under water, i.e. the current market price is higher than the price at which the currency was originally sold.

The hedge neutralizes the currency risk because in accounting terms, when summing up the value of the foreign asset and of the hedge, changes in valuation of the foreign asset and the hedge offset each other. A loss incurred on the hedge is compensated by a profit on the foreign asset. If on the other hand the foreign currency depreciates, then the hedge generates a profit that compensates a loss made on the foreign asset.  Large institutions hire overlay managers to execute the hedge.

The static hedge can be established through a bank, a specialized market maker in foreign exchange or through a futures contract.

Establishing a hedge is not free of cost, the institution has to allocate funds or provide a credit line that is used as collateral for the margin capital of the hedge. Even though the collateral earns interest, this ties up capital and thus implies an opportunity cost to the overall institution.

Another drawback of a static hedge is that the value of the hedge is as good as the timing of the hedge: when the position was opened and closed. If the institution times its hedge well, it is the big winner, but if it fails to pick the peak of the value of the foreign currency, the profitability of the hedge is disappointing.

Due to the cost of putting up collateral to fund the hedge and the need to have a good timing for the static hedge, institutions have not embraced currency hedging. They prefer to endure the risk of currency movements than to hedge their exposure. This strategy has the benefit that management has a good excuse: if overall performance is below par, they can always blame the currency markets.

Options

Another approach to currency hedging is to buy put options to offset the risk of currency depreciation. A put option gives the buyer a right to sell a defined amount of foreign currency at a specific strike price, typically the current price minus any interest rate differential between the home and foreign currency for the duration of the option.  The cost of a put option is high: typically, a put option for one year can cost as much as 10 percent of the underlying asset. So the price depreciation of the foreign asset needs to be at least 10 percent to break even. The cost of put options can be reduced by implementing a more complex option strategy, e.g., by buying a put option and at the same time, selling a call option. Such a strategy adds risk and complexity to the transaction making it more difficult to manage the hedge. Institutions rarely use options to hedge their currency risk because of the cost and complexity.

Combining static hedge with dynamic hedge

At Olsen we have developed a hedging program that overcomes the deficiencies of a static hedge. The program has two components a static hedge and a dynamic hedge. The dynamic hedge buys and sells the foreign currency in tandem with price action in the currency markets: whenever the foreign currency appreciates rapidly, the dynamic hedging program makes incremental sales of the foreign currency and buys the home currency. As soon as the foreign currency starts to drop again, the program closes out these short positions by buying the foreign currency and selling the home currency. If the foreign currency drops further, the program continues to build up the offsetting hedge by buying the foreign currency and selling the home currency.

The dynamic component can in this way take advantage of the many ups and downs in the foreign exchange markets. During the course of one year, the sum of all the up and down movements bigger than 0.05 percent are a whooping 1600 percent for a typical exchange rate after accounting for transaction costs.  The price curve with all its up and down movements is the coastline of the exchange rate. The dynamic hedging program takes advantage of the length of the coastline and the temporary price overshoots, which are then reversed, to increase  and reduce the total size of the hedge to generate incremental return.

Let me give an example:

If the foreign asset has a value of 100 units, then the static hedge is short 50 units of the foreign currency and long the equivalent amount in home currency. The net exposure of the investor to the foreign currency is then 50 units. In addition to the static hedge, the Olsen program includes  dynamic positions that are opened and closed in response to the price overshoots. The dynamic hedge can in an extreme situation, when the foreign currency appreciates rapidly, increase the hedge by selling an additional 50 units of the foreign currency and buying the equivalent of home currency; the hedge is then the same size as the foreign asset.  If the reverse happens and the foreign currency drops rapidly, the dynamic hedge starts to buy the foreign currency and incrementally builds up a long foreign currency position that offsets the static hedge. In an extreme situation, the dynamic hedge may be as large as the static hedge thus equivalent to a closeout of the hedge.

The advantage of this approach is that the overall size of the hedge changes dynamically. Whenever the foreign currency appreciates rapidly, the dynamic hedge adds to the overall hedge, whenever the foreign currency drops rapidly, the total hedge size is reduced. By dynamically changing the overall size of the hedge the program generates a profit, which is welcome revenue that can offset the opportunity cost of setting aside margin capital for hedging.

The dynamic hedge is a benefit because it reduces the importance of getting the timing of the static hedge right – if the static hedge was initialized at an inopportune time, when the foreign currency had already dropped, then the dynamic hedge will make up for some of the lost opportunity.

Most importantly, the dynamic hedge increases the size of the hedge. Whenever the foreign currency appreciates; the dynamic hedge reduces the size of the hedge, and whenever the foreign currency depreciates, the dynamic hedge cushions the impact of the price movements of the foreign currency and reduces risk by lowering volatility of the net value of the foreign asset including its hedge. Differen to the option strategy, which costs money, if the price moves do not happen as expected, the dynamic hedging strategy does not cost money because the profits from the dynamic hedge pay for the opportunity cost of the capital dedicated to the hedging strategy.