How do you know if investors as a whole have high or low risk aversion?
Unfortunately, it is difficult to measure investor risk aversion with a single number.
One way to get a broad idea of risk aversion levels is to look at the different yields that bonds pay. The wider the difference, or…
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Time Horizon In general, a carry trade is a long-term strategy. Before entering into a carry trade, an investor should be willing to commit to a time horizon or at least six months. This commitment helps to make sure that the trade will not be affected by the "noise" of shorter-term currency price movements. Also, not using excessive leverage for carry traders will allow traders to hold onto their positions longer and to better weather market fluctuations by not getting stopped out.
To summarize: Carry trade investors should be aware of factors such as currency appreciation, trade balances, and time horizon before placing a trade. Any or all of these factors can cause a seemingly profitable carry trade to become unprofitable,
FUNDAMENTAL TRADING STRATEGY: STAYING ON TOP OF
The best way to highlight the significance of these events is through examples.
G-7 Meeting, Dubai, September 2003
The countries that constitute the G-7 are the United States, United Kingdom, Japan, Canada, Italy, Germany, and France. Collectively, these countries account for two-thirds of the world's total economic output. Not all G-7 meetings are important.
The only time the market really hones in on the G-7 finance ministers meeting is when big changes are expected. The G-7 finance ministers meeting on September 22, 2003, was a very important turning point for the markets. The dollar collapsed significantly following the meeting at which the G-7 finance ministers wanted to see
“more flexibility in exchange rates”. Despite the rather tame nature of these words, the market interpreted this line to be a major shift in policy. The last time changes to this degree had been made was back in 2000.
Figure 9.9 EUR/USD Post G-7 Chart (Source: eSignal. www.eSignal.com)
In 2000, the market paid particular attention to the upcoming meeting because there was strong intervention in the EUR/USD the day before the meeting. The meeting in September 2003 was also important because the U.S. trade deficit was ballooning and becoming a huge issue. The EUR/USD bore the brunt of the dollar depreciation while Japan and China were intervening aggressively in their currencies.
As a result, it was widely exacted that the G-7 finance ministers as a whole would issue a statement that was highly critical of Japans and Chinas intervention policies, leading up to the meeting, the U.S. dollar had already begun to sell off, as indicated by the chart in Figure 9.9. At the time of the announcement, the EUR/USD shot up 150 pips. Though this initial move was not very substantial between September 2003 and February 2004 (the next G-7 meeting), the dollar fell 8 percent on a trade- weighted basis, 9 percent against the British pound, 11 percent against the euro, 7 percent against the yen, and 1.5 percent against the Canadian dollar. To put the
percentages into perspective, a move of 11 percent is equivalent to approximately 1.100 pips. Therefore the longer-term impact is much more significant than the immediate impact, as the event itself has the ability to change the overall sentiment in the market. Figure 9.9 is a weekly chart of the EUR/USD that illustrates how the currency pair performed following the September 22, 2003, G-7 meeting.
Political Uncertainty: 2004 U.S. Presidential Election
Another example of a major event impacting the currency market is the 2004 U.S. presidential election. In general, political instability causes perceived weakness in currencies. The hotly contested presidential election in November 2004 combined with the differences in the candidates' stances on the growing budget deficit resulted in overall dollar bearishness. The sentiment was exacerbated even further given the lack of international support for the incumbent president (George W. Bush) due to the administrations decision to overthrow Saddam Hussein. As a result, in the three weeks leading up to the election, the euro rose 600 pips against the U.S. dollar. This can be seen in Figure 9.10. With a Bush victory becoming increasingly clear and later confirmed, the dollar sold off against the majors as the market looked ahead to what would probably end up being the maintenance of the status quo. On the day following the election, the EUR/USD rose another 200 pips and then continued to rise an additional 700 pips before peaking six weeks later. This entire move took place over the course of two months, which may seem like eternity to many, but this macroeconomic event really shaped the markets; for those who were following it, big profits could have been made. However, this is important even for short-term traders because given that the market was bearish dollars in general leading up to the U.S.
presidential election, a more prudent trade would have been to look for opportunities to buy the EUR/USD on dips rather than trying to sell rallies and look for tops.
Figure 9.10 EUR/USD U.S. Election (Source: eSignal. www.eSignal.com)
Wars: U.S. War in Iraq
Geopolitical risks such as wars can also have a pronounced impact on the currency market. Figure 9.11 shows that between December 2002 and February 2003, the dollar depreciated 9 percent against the Swiss franc (USD/CHF) in the months leading up to the invasion of Iraq. The dollar sold off because the war itself was incredibly unpopular among the international community. The Swiss franc was one of the primary beneficiaries due to the country's political neutrality and safe haven status. Between February and March, the market began to believe that the inevitable war would turn into a quick and decisive U.S. victory, so they began to unwind the war trade. This eventually led to a 8 percent rally in USD/CHF as in- vestors exited their short dollar positions.
Each of these events caused large-scale movement in the currency markets, which makes them important events to follow for all types of…
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all have solid correlations with gold prices; natural gold reserves and currency laws in these countries result in almost mirror-like movements. The CAD also tends to move somewhat in line with oil prices; however, the connection here is much more complicated and fickle. Each currency has a specific correlation and reason as to why its actions reflect commodity prices so well. Knowledge of the fundamentals behind these movements, their direction, and the strength of the parallel could he an effective way to discover trends in both markets.
The Relationship
Gold Before analyzing the relationship gold has with the commodity currencies, it is important to first understand the connection between gold and the U.S. dollar.
Although the United States is the worlds second largest producer of gold (behind South Africa), a rally in gold prices does not produce an appreciation of the dollar.
Actually, when the dollar goes down, gold tends to go up, and vice versa. This seem- ingly illogical occurrence is a by-product of the perception investors hold of gold.
During unstable geopolitical times, traders tend to shy away from the dollar and instead turn to gold as a safe haven for their investments. In fact, many traders call gold the "antidollar." Therefore, if the dollar depreciates, gold gets pushed up as wary investors flock from the declining greenback to the steady commodity. The AUD/USD, NZD/USD, and USD/CHF currency pairs tend to mirror gold’s move- ments the closest because these other currencies all have significant natural and political connections to the metal.
Starting in the South Pacific, the AUD/USD has a very strong positive correlation (0.80) with gold as shown in Figure 9.12; therefore, whenever gold prices go up, the AUD/USD also tends to go up as the Australian dollar appreciates against the U.S. dollar. The reason for this relationship is that Australia is the worlds third largest producer of gold, exporting about $5 billion worth of the precious metal annually. Because of this, the currency pair amplifies the effects of gold prices twofold. If instability is causing an increase in prices, this probably signals that the USD has already begun to depreciate. The pairing will then be pushed down further
as importers of gold demand more of Australia's currency to cover higher costs. The New Zealand dollar tends to follow the same path in the AUD/USD pairing because New Zealand's economy is very closely linked to Australia's. The correlation in this pairing is also approximately 0.80 with gold (see Figure 9.13 for the chart).
Figure 9.12 AUD/USD and Gold
Figure 9.13 NZD/USD and Gold
The CAD/USD has an even stronger correlation with gold prices at 0.84, …
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Figure 9.13 CAD/USD and Oil Trading Opportunity
Now that the relationships have been explained, there are two ways to exploit this knowledge. Taking a look at Figures 9.12, 9.13 and 9.14, you can see that generally speaking, commodity prices are a leading indicator for currency prices.
This is most apparent in the NZD/USD-gold relationship shown in Figure 9.13 and the CAD/USD-oil relationship shown in Figure 9.14. As such, commodity block traders can monitor gold and oil prices to forecast movements in the currency pairs.
The second way to exploit this knowledge is to parlay the same view using different products, which does help to diversify risk a bit even with the high correlation. In fact, there is one key advantage to expressing the view in currencies over commodities, and that is that it offers traders the ability to earn interest on their positions based on the interest rate differential between the two countries, while gold and oil futures positions do not.