Callum Henderson’s “Currency Approach” provides a good review of advanced currency trading theory and practical strategy. Macro Ops.

Although it reads like a textbook and is slightly antiquated (it was released in 2000), the book’s major points are still relevant and valuable today.

These Ops Notes cover crucial book parts for traders. Corporate currency hedging and technical analysis were omitted. If you’re serious about trading currencies, read this book. Rosenberg’s Currency Forecasting and Jessica James’ Handbook of Exchange Rates are great companions.

These Ops Notes are perfect for folks that understand currency theory and application. It’s advanced material. Future Vault posts will delve deeper into these sections. Since Currency Strategy’s Ops Notes are dense, we separated them into four sections. The first section discusses typical exchange rate modeling methodologies.

Traditional exchange rate models’ strengths and weaknesses

Traditional exchange model equilibriums. The exchange rate should reflect changes in commodity and good prices between currencies over time. Each model uses different data to calculate equilibrium exchange rates.

Inflation

Purchasing Power Parity (PPP) is the best-known exchange rate model in currency analysis. In a world without trade barriers, the price of a good must remain constant over time. To ensure this, the exchange rate must reach long-term balance. PPP holds if:

Goods trade and arbitrage are unrestricted.

Nothing is transacted

Perfectly homogenous goods are traded

Thus, PPP = P / P

P = E P.

Where

E=PPP long-term equilibrium exchange rate

P = domestic goods price

P = Foreign goods price

This reflects the PPP perspective that the long-term equilibrium value of an exchange rate is a direct function of the ratio between two countries’ “internal” prices of the same traded products.

Say a basic basket of consumer items costs more in Germany than Norway. This would lead to consumer goods arbitrage, when people buy products in Norway and sell them in Germany. They’d boost demand for Norwegian goods in the process. Demand for Norwegian Krona (used to buy those things) would rise. The Krona would become more expensive, offsetting basket price discrepancies. Arbitrage balances currencies.

Cheap currency attracts purchasers, increasing demand for commodities and currency appreciation.

Practitioners consider base and term currencies. The base currency is usually US dollars.

The US-Japan exchange rate is dollar per yen, not yen per dollar. Dollar is base, yen is term. So quote forex dealers. Our PPP formula could read:

E=PT/PB

Where:

E=PPP long-term equilibrium exchange rate

P tb=Term currency price level

P=Base currency price

Misalignment

Misaligned exchange rates are expected to revert.

A reasonable, profit-seeking market should quickly eradicate transient price or exchange rate distortions that produce misalignments. “Misalignments” might span months or years. The PPP model’s short-term record is poor. “Pretty Poor Predictor” is its nickname.

Because:

Free trade would include zero import tariffs, zero export subsidies, and perfect competition across all business sectors. Obviously not. Trade-related pricing (and exchange rate) distortions result.

During market volatility, companies may delay setting prices and budgeting exchange rates. They may wait till they know what competition and margin levels are.

A common PPP assumption is that the relative price of commodities drives exchange rates. However, this may not be the case. Since capital market liberalization and speculation on exchange rates, this may no longer be true.

In different countries, a good or basket of goods may be slightly different. “Same” goods may vary in quality, cost, and market speed between countries.

When to start PPP analysis depends on base-year impacts. Changes in PPP require a base year. Logic could advise starting from the conclusion of Bretton Woods in 1971–1973, but this was a time of severe inflation, confounding outcomes.

The Economist’s “McParity” index analyzes the adjusted pricing of Big Macs from around the world to compare PPP.

1.1.4 PPP and RER

1. The real exchange rate adjusts for inflation (price) differentials.

Long-term PPP should maintain the real exchange rate.

A nominal exchange rate adjustment will counteract inflation differentials across countries.

2. Lastly:

PPP provides a medium-to-long-term currency value perspective. Long-term real exchange rate stability depends on PPP.
Short-term divergences from PPP are possible.
PPP is useful for corporations, long-term investors, and leveraged investors, but not for short-term traders.

Using Money

1. Classical theory says a country’s price level depends on its money supply. PPP says exchange rates adapt to equalize country prices. If money influences prices, it must likewise affect exchange rates. Transition theory:

• Money supplypriceexchange rate
• Money supplyinterest rateexchange rate

Rising money supply likely owing to lax monetary policy from the central bank. Under PPP’s one-price law, freely tradable products must be the same price everywhere across time. Adjusting exchange rates is needed. As prices rise in one country relative to another, the currency must decline to restore equilibrium. The exchange rate often lags behind monetary developments. “Sticky” prices emerge from this delay. In fact, we get something like:

Delayed money supply, price, and exchange rate changes

A currency’s rising money supply should depreciate. As the currency depreciates, supply will rise until demand rises. Here, the currency will stabilize and recover.

Mundell-Fleming

1. A central bank cuts interest rates in a high-capital-mobility economy. Weak growth and low inflation prompted rate cuts.

Lower rates lower the motivation to retain interest-bearing instruments. Risk doesn’t pay off. Relatively, holding cash or money becomes more attractive.

This should cause the currency rate to depreciate, restoring the trade balance.

Lower interest rates cause capital outflows, which devalue the currency.

2. Whether trade or capital flows dominate fiscally is crucial.

Tax cuts or spending increases should stimulate domestic demand, which should worsen the trade balance.

Looser fiscal policy raises domestic interest rates, attracting capital inflows. Trade flows should devalue the exchange rate.

3. Mundell–Fleming says stricter fiscal policies should reduce domestic demand.

This should lower import demand, improving trade balance.

Tighter fiscal policy should lower interest rates, causing capital outflows.

If trade flows dominate, the exchange rate should gain; otherwise, it should fall.

4. Capital flows dominate commerce flows in a world with perfect or high capital mobility. Table 1.2 shows the impact of monetary and fiscal policy on currency rates.

The idea that a change in monetary policy automatically affects the exchange rate is erroneous.

Transmission may be delayed.

Standard models may overestimate the initial exchange rate reaction.

The Mundell–Fleming model of policy combinations helps predict future exchange rate direction. Short-term delays and distortions may delay findings.

1.2.4 Not Three Legs

1. In a world with high capital mobility, a central bank can target either the exchange rate or the interest rate, but not both. You can have two but not all three:

• Fixed exchange rate
• Monetarist autonomy
• Mobile capital

2. First assumes exchange rate targeting, second inflation and interest rate targeting.

Rate-based approach

1. First, interest rate parity states:

Forward premium/discount = interest rate divergence

2. The dollar–yen forward discount should equal the interest rate differential.

This is the exchange-rate-interest-rate equilibrium.

Forward premium or discount can change short due to supply and demand, but should always return to norm.

If the forward premium/discount didn’t equal the interest rate differential between the two currencies, an arbitrageur could make risk-free profits by borrowing in one currency, investing in the other currency’s securities, and opening a forward contract in the exchange rate for the same period as the initial loan. Covered rate arbitrage.

(Sidenote: Alex here. Covered interest arbitrage or parity has broken down since the financial crisis in 2007. Alhambra Partners’ Real Vision presentations are also good.)

1. Interest rate parity theory asserts that the difference between a spot and future exchange rate should equal the interest rate differential between the two currencies. The PPP principle links exchange rates with inflation. Can these be linked to interest rates? Thanks to Irving Fisher, we can.

“Fisher effect” states:

Interest rates = anticipated inflation rates

2. Thus, the difference between the spot and forward exchange rates equals the interest rate differential through the interest rate parity theory, which equals projected inflation rates through the Fisher effect. PPP says absolute or relative price growth can predict future exchange rates.
3. Through PPP, we can conclude:

Projected inflation minus expected exchange rate change

Together, we get:

Spot minus ahead Equals interest rate difference (Interest rate parity theory)

Interest rates = anticipated inflation rates (Fisher effect)

Difference in projected inflation rates Equals spot exchange rate change (Purchasing Power Parity)

The difference between the spot and forward rates, represented as a percentage, should equal the predicted change in the spot exchange rate.

Interest rate differential = anticipated spot exchange rate change (International Fisher effect)

Long-term, the interest rate parity theory works as market participants “find” possibilities for covered interest rate arbitrage across currencies and interest rates, decreasing discrepancies. Longer lags exist than the theory suggests.

Again, incentives are key. Theorists should know that most currency market practitioners are interbank dealers and that their main incentive to trade is directional gain rather than interest income. Currency markets do focus on interest rate differentials for extended periods of time, but they also focus on other factors, in many cases ignoring interest rates.

1.3.1 Real IRDs and Exchange Rates

1. Currency strategists utilize models to compare real interest rate differentials with nominal or real exchange rates.

The argument pertains to both the international Fisher effect and PPP, where the difference in interest rates should, if not exactly equal to a projected change in the market exchange rate, at least be an important driver of it.

Inflation-adjusted nominal interest rate differentials relate to the exchange rate through the law of one price.

The correlation between real interest rate differentials and the currency rate appears to have risen since the dissolution of Bretton Woods to liberalize global capital flows.

As capital movement obstacles fell, capital flow’s importance grew exponentially relative to trade flow.

As capital flows gained importance, so did their relevance within broader currency market flows, increasing their link.

Thus, currency strategists throughout the market continue to follow this relationship as one of many valuable and essential indications of currency over- or undervaluation.

Balance-of-payments method

1. Changes in national revenue affect both the current and capital accounts, causing a predictable exchange rate reaction to restore balance of payments equilibrium. Examine how the shift in national income affects the exchange rate.
2. Consider the standard accounting identity for economic adjustment when using the Balance of Payments Approach to exchange rates.

SI=YE=XM

where:

S=Save

Invest

Y=Profit

Spending

exports

Imports

This law guides how economies react to changing economic dynamics.

Fixed exchange rate

1. In a fixed exchange rate regime with restricted capital mobility, the current account is prioritized.

a. Since the exchange rate is set, it can’t restore BOP balance.

i. The monetary authority can sell foreign exchange reserves to ease exchange rate pressure or tighten monetary policy to reduce domestic demand, import demand, and restore balance of payments equilibrium.

2. In a fixed exchange rate regime, a change in national revenue is transmitted through the current account balance.

National income change Current account balance change Monetary reaction Current account balance change reversal Balance of payments equilibrium restored

1.4.2 Floating exchange rate

1. In a floating exchange rate regime, we must examine the capital account.

a. As income rises, import demand rises, worsening the current account balance.

b. In a floating exchange rate environment, the exchange rate can restore BOP balance.

i. A growth in national income, which worsens the current account balance, must be accompanied by higher real interest rates.

ii. Higher real interest rates will reduce import demand, reversing the current account deficit.

iii. As national income falls, real interest rates will also.

Real interest rates rise when the current account improvement reverses. In a floating exchange rate regime, a change in national revenue affects the balance of payments.

Changes in national income, current account balance, real interest rates, and capital flows were reversed, restoring balance of payments equilibrium.

REER/FEER

1. REER is the trade-weighted exchange rate (NEER) adjusted for inflation, following the external balance approach.

a. REER measures an exchange rate’s over- or undervaluation relative to a norm.

2. Significant REER overvaluation relative to 100 tends to worsen the current account deficit or “external imbalance”

a. To restore balance, REER must depreciate. This can be done by depreciating the trade-weighted exchange rate or by reducing inflation.

3. Long-lasting REER overvaluation is possible. In some circumstances, removing overvaluation can take years.
4. REER can diagnose over- or undervaluation and the need for an adjustment to restore equilibrium, but it can’t tell you when.
5. FEER, or Fundamental Equilibrium Exchange Rate, estimates real exchange rate equilibrium.

a. FEER reflects the exchange rate value that results from a current account surplus or deficit that is proportionate to long-term structural capital inflow or outflow in the economy, providing the country has no trade barriers and is pursuing internal balance.

b. Assessing long-term capital inflow or outflow needs value judgment.

c. FEER-based models have been utilized in the commercial sector for years. Adopting this form of exchange rate model emphasizes the analyst’s value judgment, undercutting the aim of using a model.

1.4.5 Tariffs

1. The so-called “terms of commerce” are the relationship between a country’s export and import prices. Trade terms can affect a country’s long-term equilibrium real exchange rate.

a. Rising export prices should represent both absolute and relative worldwide demand for a country’s exports.

i. An improvement in trade terms should lead to a better current account balance, which necessitates a real exchange rate appreciation to restore equilibrium.

ii. A worsening in trade terms leads to a deterioration in the current account, which necessitates a real exchange rate depreciation to restore balance. For clarity, consider the following diagram:

Changes in trade terms, current account balance, and real exchange rate restore equilibrium.

Productivity

1. Rising productivity boosts supply. Increased supply relative to demand lowers prices.

The Purchasing Power Parity principle demands that declining prices in one country lead to an offsetting exchange rate appreciation.

Higher productivity growth in tradable commodities should increase the exchange rate to balance the current account.

2. Like PPP, productivity growth shouldn’t be utilized as a short-term trading model.
3. Both can predict medium- to long-term exchange rate changes.

Balanced Portfolio

1. The Portfolio Balance Approach focuses on domestic and foreign bond prices and the exchange rate.

a. A change in monetary and/or fiscal conditions will affect the supply and demand for domestic and foreign bonds, which will affect the exchange rate.

2. Assume that a cut in interest rates by the central bank promotes outflows from domestic interest-bearing securities into money/cash. If domestic bond supply remains unchanged, falling interest rates should diminish bond demand.

a. This should enhance demand for foreign currency bonds, depreciating the domestic currency against the foreign. Similarly, if the central bank raises interest rates, this should cause a domestic currency appreciation.

3. This Portfolio Balance Approach is basic. It’s a poor predictor of exchange rates because it ignores the real-world realities of a fixed-income fund manager making asset allocation decisions.

1.6

1. It is natural to presume that classic exchange rate models should be changed to fit modern currency market dynamics.

a. Trade flows, the basis for the PPP, Balance of Payments, and External Balance Approaches, were long thought to drive currency market overall flow.

i. They make up 1–2% of the USD5.3 trillion in daily currency market volume. As trade’s importance to total market flow has dropped, so has the relevance of exchange rate models that rely purely on trade flow patterns.

ii. As trade flows have diminished in importance during the past two decades, portfolio flows have expanded tremendously. The Portfolio Balance Approach focuses on asset markets, notably the bond market, as a driver of exchange rates, although this model is unreliable for the reasons indicated.

To predict short-term exchange rate movement, we must determine the key flow drivers.

• Flow “speculative” (without an underlying attached asset)
• Equity & bond flow
• Investments directly
• Commerce