Introduction:

There are various views of how market mechanisms work, but broadly speaking there are those that believe that every piece of available information is priced into the markets and therefore at any given time the interaction of supply and demand gives a value for any security whether it bonds, stocks or currencies. On the other hand, and most traders would agree, that a currency can deviate from fair value if only for an hour and this leads to trading opportunities. My aim is to look into ways of how to value a currency rate and from there how to trade from it.

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Purchasing Power Parity:

Purchasing power parity (PPP) is a measure of a currencies real value when purchasing actual good, for example, once you've taken your Euros and seen the amount you can get in dollars and then compare that to the relative value of two identical goods in various currency zones. The most commonly referred to study on this is the famous "Big Mac Index" produced by The Economist. This is looking at the cost of a McDonalds Big Mac and converting it into US dollars at the Current FX rate. From here you can see whether or not there is a disparity between different currencies. There are however flaws with this, these include; differences in the cost of the factors of production - Higher wage costs, lower beef prices etc. and so this causes mild anomalies within all the factors considered but because of the size and scope of the Mcdonalds as a company these issues are less of a concern due to the market power.

Below shows the latest 2013 data for relative over/under valuations against the USD for a select number of countries using the Big mac index.



There is a general trend across this data where developed OECD nations have overvalued countries and Emerging nations have undervalued currencies but this correlation is broad and without much causation.

Given the data here is a table of some of the actual and implied FX rates.



Of course when looking at this list of data the vast majority is untradable as with AUDUSD and GBPUSD there is such a small differential that the implied value can fall within the daily range of these pairs. But for some of the other pairs a general theme of USD undervaluation is seen expect with the Mexican Peso.

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Fundamentals:

Fundamentals, especially today in our low growth trudge through the years is becoming more and more important. Because of the paradigm shift away from risk within in the markets (consider HY-IG spreads and XO CDS spreads). The recovery story from each major economy will leak directly into the exchange rate more so than the last 5 years. One to consider is the rather impressive rally of nearly 700 pips in the GBP/USD over the last few weeks purely on improving "relative" fundamentals. I won't dive into too much detail on how fundamentals can be used in trading as I have mentioned it before and there are some other articles that cover the same point. But a main theme that they're forgetting is how the current macro situation has changed and now the US with 2.5% growth has seen a strong USD where as before 2.5% would be considered weak.

I have made a rough table of current fundamentals and outlook on the overall economy. I've taken in to account - GDP, Inflation, Debt-GDP, Deficit as a % of GDP, Housing markets, unemployment and a few others like velocity of money.



From this the rational fundamental trades would be short AUD, EUR and long GBP and USD. JPY, CAD where marginal and the BoJ make the JPY unfavourable through intervention fears. There is however no quantifiable level to which each currency is over or under valued but more of a guide that some currencies should depreciate or appreciate over time.

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Swap Markets:

Every seasoned FX trader understands the importance in overnight swaps when determining the value and expected value of an FX rate. In its basic form it can be seen as the differential between the two respective interest rates but its not that simple in the actual world. They can be traded and changed in the secondary markets by trading forwards and swap contracts and so inter market divergences can occur and from here you can determine a "swap fair-value" for a respective currency pair.

These are very tradable divergences and this year in particular swap trading has been incredibly profitable.

Below are a variety of FX pairs and their relative 1Y swaps overlayed:


First of is the AUDUSD vs the swaps, for a long time the AUD has been "overvalued" and this has, while not directly pushed it lower, has meant that it struggled to stay well above 1.05 for any period of time as the swaps markets weren't coherent with the rally in the FX pair. There is still a long way to go with the AUD 1Y swaps pricing in a fair value AUDUSD at approximately 0.80.


Next shows the EUR swaps vs the EURUSD. If you don't have access to the EUR swaps, then the German 2Y bund yield is very analogous to the swaps for various reasons, firstly unlike using central bank depo rates investors prefer using short term bonds to store money in various countries and as Germany is the safest in Europe then this is the preferred choice. Once again most divergences have closed and the swaps price in a 1.22 EURUSD, incidently the same level as the PPP as per the big mac index.


This 3rd chart shows GBP swaps and is very useful in explaining the large drop at the beginning of the year as the fair value GBPUSD was below 1.50 where as the GBPUSD was actually trading above 1.60 and obviously the depreciation will occur.



Finally swedish swaps, not a commonly traded pair but is currently showing a rather large divergence. This is one of the cases where the FX pair may be less likely to move and the swap is likley to move towards the FX rate.

Finally here is a bonus chart showing the USDJPY swaps vs. the USDJPY fx rate


This is a very disturbing chart for the Yen bears out there as the swaps have been unchanged throughout the recent rally in USDJPY. This goes against convention and means the move is unsustainable, for me it is unlikely for the USDJPY to drop back to 0.75 but the swap traders are less doubtful.

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Conclusion:

Overall I believe in the idea that currencies can be distorted in price, just consider central bank intervention that purposely devalues a currency and this causes supply & demand issues and allows for opportunities whether they lie in the supply chain and relative purchasing power of a currency, the underlying fundamentals of a currency or in fact the swap-defined fair value level.

In conclusion taking the ideas from each of the 3 sections with in this article the most sensible longer term moves across some of the major currency pairs would be.

Strong USD
Strong GBP
Strong JPY - N.b. difficult due to BoJ
Average MXN
Average CAD
Weak EUR
Weak AUD
Weak SEK

Thank you for reading.

Adrian.







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