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Currency Management and Correlation in Turbulent Markets

With Jason A. Moore

As markets enter a new period of risk aversion with global policy makers tip-toeing through the minefields of sovereign risk and the delicate wind down of stimulus programs, currency management can address an array of investment policy objectives. These include traditional passive hedging strategies designed to reduce the long term volatility of diversified international portfolios and portable alpha strategies that aim to provide a diversifying source of portfolio returns.

Financial academic theory has long understood that unmanaged covariance (the co-movement of returns in different asset classes, as measured by correlation and volatility) has a potentially corrosive effect on portfolio returns. If market professionals didn't pay attention to this aspect of risk management before, it's likely that they do so today.

One of the single greatest lessons of the recent financial crisis may be that traditional and non-traditional asset classes are increasingly intertwined, with correlation accelerating as volatility erupts. But during market turbulence, when other asset returns are herding into massively aligned defensive positions, currency alpha returns go their own way.

Recent research by State Street Associates, the research partnership between financial academics and State Street Global Markets practitioners, suggests that over the past 10 years the correlation of global equity, bonds and real estate returns significantly increased during periods of market turbulence. But during this turbulence, the average correlation of currency strategies with those asset classes actually decreased.

Turbulence

Taking advantage of market turbulence would be difficult if investors were to enter choppy markets blind. Fortunately, new research is revealing how turbulent markets evolve, how they persist, and how investors can reallocate their portfolios to manage risk more effectively or enhance alpha by taking advantage of volatility.

Quantitative financial practitioners have long sought to understand the frequency and duration of market-changing turbulence and its impact on investment correlation. And not a moment too soon. The financial crisis, together with previous dislocations, have taught us that market outliers that were once thought to be rare have become more common, with greater impact on the correlation of asset classes and on the risk profiles of diversified portfolios.

Turbulence can be defined as the arrival of extreme market outliers - statistically anomalous events that represent substantial divergence from normative models. Extreme political and financial scenarios such as the 1987 stock market crash, the first Gulf War, Russian default, the bursting of the technology, media and telecommunications bubble or the recent mortgage- and credit-driven crisis are examples of this.

True turbulence is not the manifestation of investor opinion or behavior. Rather, it is a simple statistical expression of unusual price changes. Sharp departures from normal pricing - on the upside and the downside - define turbulence. And turbulence measures can be applied objectively across any market or asset class.

In terms of asset allocation strategies, the study of turbulence reveals that traditional quantitative expressions of risk, which place equal significance on normal and non-normal markets, significantly underestimate the impact of turbulent events. Covariance estimated from market outliers provides a model of portfolio risk superior to those derived from full-sample analysis. Investors using turbulent covariance matrices to stress-test strategic asset allocations may find that active currency strategies can provide a shelter in both good times and bad.

Forward Rate Bias

The study of turbulence has implications for many asset classes. It has a profound impact on currencies and their utility for portable alpha strategies. The Forward Rate Bias Strategy (FRB) exploits the difference in interest rates between various currencies. Interest rates determine the exchange rate on forward contracts, with high interest rate currencies selling at a discount to the spot rate and low interest rate currencies selling at a premium.

While the FRB does very well in times of low volatility it tends to under-perform during turbulent markets. Armed with this understanding, managers can selectively engage and withdraw from FRB strategies in support of portable alpha programs.

For investors engaging portable alpha programs amid volatile and fast-changing markets, currency management programs, supported by emerging research in market turbulence, can defend beta positions and provide a valuable source of uncorrelated alpha.

The statements and opinions are subject to change at any time, based on market and other conditions. State Street cannot guarantee the accuracy or completeness of any statements or data. These views may not be relied upon as investment advice or an offer for a particular security.