FX volatility creates opportunities for leveraged currency ETPs

Feb 19th, 2013 | By | Category: Alternatives / Multi-Asset

After a period of relative calm, exchange rate volatility has spiked considerably over the past two months following the election of a new government in Japan. With murmurings that a “currency war” is about to break out, volatility in the foreign exchange market looks destined to remain at elevated levels for some time to come, creating opportunities for investors and traders alike.

Volatility in FX market creates opportunities for leveraged currency ETPs

Volatility in the global foreign exchange market has created opportunities for leveraged currency exchange-traded products.

After the spectacular moves seen around the time of the collapse of Lehman Brothers in late 2008, currency market volatility slowly reverted to more normal ranges, with a few exceptions over the course of 2009-2011.

In 2012, volatility dropped to such a low level that, towards the end of the year, trading ranges (the spread between highs and lows during a given period) were back to levels not seen since the pre-bust years of 2006-07. In some cases, trading ranges were near or at their lowest in decades.

Many analysts attributed the low volatility as the result of diminished interest rate differentials, with the G10’s highest yielder, the Australian dollar (AUD), featuring an overnight rate of a mere 3%. Even emerging market central banks have begun cutting rates to boost domestic economies. These central banks have taken away all systemic risks by providing endless liquidity.

The inflection point came in mid-November 2012 when the announcement of fresh elections in Japan quickly put the spotlight on Shinzo Abe, the opposition Liberal Democratic Party candidate, and his firebrand rhetoric on forcing the Japanese yen (JPY) weaker. Since then and following Abe’s assumption of office, the JPY has moved 13.5% weaker against the US dollar (USD) and 16.4% weaker versus the euro (EUR) in just three months.

FEATURED PRODUCT

ETFS 3x Short JPY Long USD ETC (SJP3)

– Provides triple-leveraged short exposure to the
Japanese yen / US dollar exchange rate (JPY/USD)

– Tracks the MSFX Triple Short JPY Long USD (TR)
Index, reflecting three times the daily percentage
change between the two currencies, the interest
differential, plus a collateral yield

– Provides a cost-efficient means of obtaining
leveraged exposure with no scope for contingent
liability; the amount invested represents the
maximum possible loss

– Trades on the London Stock Exchange similarly
to an ETF, UCITS eligible, UK Reporting Status,
eligible for ISAs and SIPPs, registered across
much of Europe, MER 0.98%

These dramatic shifts have pushed the JPMorgan Global FX Volatility Index, an index reflecting the implied volatility of three-month at-the-money G7 currency options, from 7.45 to over 9.06, an increase of more than 21%.

John Hardy, Head of FX Strategy at Saxo Bank, points to two key drivers of foreign exchange volatility at present. The first one is the politicisation of central banks, which has already appeared in Japan, but is soon to come to the West if Mark Carney implements radical new efforts to help the UK achieve “escape velocity” on his arrival at the Bank of England.

The second is the increasing recognition that central banks exercise the greatest degree of power over a nation’s currency and economy, power that national governments would prefer to hold sway over themselves as the voting populations demand improvements and accountability from political leaders.

According to Hardy, “the more specific driver in the near term for FX volatility will be the international response to Japan’s dramatic recent move. Fasten your seatbelts and watch volatility and dramatic swings in the currency market rise from here. The market is in the process of making the uncomfortable transition from the former paradigm of merely bidding up all risk assets on the theory that central banks will forever provide a free ride, to the new paradigm driven by the implication of global currency wars as nation after nation moves aggressively to get the upper hand in the mud wrestling match of competitive devaluation.”

With exchange rates in a state of flux, heightened volatility creates interesting opportunities for traders looking to speculate on further shifts in the market. Indeed, a number of exchange rates appear somewhat out of kilter with fundamentals. The Australian dollar has been highlighted as potentially overvalued, while sterling (GBP) is widely anticipated to depreciate further. The Renminbi (CNY), by contrast, is generally perceived to be undervalued and expected to appreciate as Chinese authorities realign China’s economy towards domestic consumption. An effective way to capitalise on these shifts is via leveraged exchange-traded products (ETPs) which amplify the returns of selected currency pairs.

In Europe, London-based ETF Securities is the leader in this space while in the US ProShares offers the largest range. ETF Securities’ leveraged range encompasses three-times geared long and short ETCs (exchange-traded certificates) on a number of the major USD and GBP currency pairs, including AUD/USD, GBP/USD, USD /JPY, EUR/USD, GBP/AUD, GBP/JPY and GBP/EUR.

The ETCs, which are listed on the London Stock Exchange and aimed at sophisticated investors, are linked to triple-leveraged currency indices developed by Morgan Stanley. Each index reflects the performance of a fully collateralised leveraged position in currency forward contracts which are rolled on a daily basis. The indices provide exposure to movements in exchange rates between currencies and an interest differential component based on the target interest rate less local borrowing costs.

ETFS 3x Short JPY Long USD ETC (SJP3)

ETFS 3x Short JPY Long USD ETC (SJP3) (Source: LSE prices)

For example, the ETFS 3x Short JPY Long USD ETC (SJP3) is linked to the performance of the MSFX Triple Short Japanese Yen Index (Total Return). This index aims to reflect three times the daily percentage change between the two currencies, the interest rate difference, plus a collateral yield on the cash invested. Putting technicals aside, the security is essentially designed to increase in value by a factor of three when the yen depreciates against the US dollar and decrease in value by a factor of three when the yen appreciates against the dollar.

To demonstrate this in action, the security has gained an impressive 51.2% since the announcement of fresh elections in Japan (16 November 2012, see chart) compared to 15.5% for the underlying exchange rate (USD/JPY). While the performance differs from a straight trebling of the percentage change in underlying rate (owing to the effect of compounding, the premium/discount to NAV, the interest rate and the collateral return), the amplified rate of return demonstrates the potential these products have to seriously enhance portfolio returns.

Of course, all leveraged products require extra caution as losses can easily be racked up. Had the yen strengthened, for example, the ETFS 3x Short JPY Long USD ETC (SJP3) would have lost money at a rate far in excess of the underlying exchange rate movement. However, if used appropriately and within a risk-controlled environment, leveraged currency ETPs offer traders and investors an effective tool to capitalise on continued exchange rate volatility and profit from the ensuring “currency war”.

For investors looking for something a little tamer, ETF Securities offers an even larger range of non-leveraged products covering the G10 currencies, the Chinese yuan (renminbi) and Indian rupee. db X-trackers also has useful products in the non-leveraged space, offering exposure to a number of currencies including the US dollar, Singapore dollar (SGD) and Australian dollar. In the US, Guggenheim CurrencyShares and Barclays iPath also offer an array of non-leveraged currency ETPs.


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