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 this exclusive interview with FXstreet.com, Richard 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.

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Richard Olsen: I don’t think so. However, the current distortions in the market show that the economic mechanisms behind the foreign exchange markets are not understood well enough. In particular, the fact that the economy is not static, but in a constant state of change, is ignored. The situation is comparable to classical physics before 1900: only Einstein’s theory of relativity, which took the dynamical behaviour into account, allowed for a breakthrough.

So economics needs a new Albert Einstein?

RO: It needs new ideas. Indeed, there already exist new scientific models and algorithms, which incorporate the dynamical aspects. Now it is all about applying them. The methodology of High Frequency Finance offers a possibility.

Does this mean that the attempts of the recent crisis summit addressing the strong Swiss franc have fallen short?

RO: The problem is, that people try to directly influence the level of exchange rates. This, however, destabilizes the whole currency system even more.

What advice would you give the Swiss currency experts?

RO: A first step would be to dampen the massive exchange rate fluctuations in the franc. For instance, this could be achieved if exporting firms would hedge their foreign exchange risk dynamically. Thus buying Euros now as long as it is cheap, and selling when the franc drops again. This would substantially stabilize the exchange rate of the franc.

But hedging is the business of banks. Does this really require the presence of the government?

RO: Not necessarily. There simply has to be a clear signal that new solutions exist and are ready to be utilized. It takes courage to do new things, but necessity begets ingenuity. We need to support this process of innovation.

Will the franc become stronger against the Euro?

RO: The franc has risen strongly against the Euro in the last five weeks. This can hardly continue at the same rate, particularly as the exchange rate rise can most probably be attributed to the low liquidity around the holidays and the subsequent re-buying. Another recovery of the Euro rate is therefore probable.

But the fact that the eurozone countries currently don’t agree on the amount of funding for rescuing the Euro hardly speaks for it?

RO: Europe has many problems. But the impact of such news on the exchange rate is smaller than one would think: 95 percent of an exchange rate volume is based on speculation and only 5 percent can be ascribed to the real economy. The exaggerations seen in the rates occur because speculators are being forced to sell at a certain price, if they hit their stop loss, lowering the rate even more and scaring off more investors, similar to a herd of sheep plummeting over a cliff.

The Dollar is also under pressure. The Fed will soon be deciding on the interest rates – can they change the course of things?

RO: Here also, has it become evident that the wrong recipes are being applied. Interest rates in the financial system are not paid in a continuous manner but daily. This is in contrast to the financial markets where huge volumes can be traded in a split second. The market does not need more liquidity but interest rates paid every second for intervals of minutes or hours. This would also remedy the side effects of low daily interest rates.

Contrary to the USA, China is increasing the prime rates more and more aggressively: as a result, will the frictions in the foreign exchange market increase yet again?

RO: For the foreign exchange market the central banks appear as imps, who fix everything behind the curtains. Meanwhile however, there has been no consensus among them. In a dynamical system this leads to an increasing imbalance. Yes, the friction in the foreign exchange market will increase strongly.

Higher interest rates are commonly put forward as an argument to invest in the currencies of emerging countries.

RO: From the point of view of a diversification strategy this makes sense. However, it should not be forgotten that in the booming emerging nations, prices can also increase strongly, for instance for property. This can be very risky.

Given the risks, opacity and often the unfavorable spreads, shouldn’t private investors totally avoid the foreign exchange market?

RO: There is a big demand for currency investments and these requirements should be covered. Investors should, however, better focus on lower but steadier returns and minimized risk. The partly dubious offers that are available are, if nothing else, due to the fact that large suppliers are not innovative enough and charge very high prices. A little modesty would also benefit the foreign exchange business.

(Source: Handelszeitung)

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.