The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CURRENCY SELECTION

There are many theories about currency-value determination. The most popular fundamental ones are based on (1) purchasing power parity (PPP), (2) trade balances/capital flows, (3) real interest rate differentials, and (4) growth rates and growth prospects. None of these are very satisfying. Each has proved important but the importance of any one has varied over time. Therefore, technical analysis of the currency markets is quite prevalent.

The portfolio manager must decide upon the relative weights of each of the factors, in conjunction with technical analysis since, most often, the signals will be mixed. For example, PPP may be positive for the currency while the trade balance is negative. The portfolio manager must also consider the influence of cartels, such as European Monetary Union efforts and central bank intervention in the currency markets. A simplified analysis is provided below:

The yen/dollar forward values are derived from the prevailing interest rate term structure differentials between the two markets. For example, 5% difference in one-year rates between the United States and Japan yields an approximate 5% drop in one-year forward currency values. However, forward currency values are affected by other variables as well. So, one can express the conviction that the interest rate term structure differentials are not fully incorporating the influence of those other variables by being long or short the forward currency exchange rates.

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