Currency Trading: The Speculator’s Dream or an Acceptable Hedge Fund Strategy?

forex market hedge fund strategy

I was asked the other day whether I thought that currencies were an acceptable asset class for

hedge funds, the implication, presumably, being that otherwise they were just the speculator’s dream.  The following comments reflect my own personal opinions.

To address the last point first, I would suggest that any liquid market with volatility is a speculator’s dream and the currency markets have, and always have had, those two characteristics in abundance.  Of course, ignoring speculation for speculation’s sake, currencies play an important part in almost any investment made by a global investor.  But I will come to that later. 

In the context of hedge fund managers, probably the best-known name is George Soros and he became the best-known  name because he was credited with taking down Sterling at  the time of the EMU crisis when the UK were forced to leave the European Monetary Union.  Soros was reputed to have taken $1 billion out of the market on that particular transaction, which was, at the time, an enormous amount of money - indeed, it is not too shabby a sum today.  That was, perhaps, the epitome of a ‘macro’ trade or investment, but it was, nevertheless, speculation for speculation’s sake and there’s nothing wrong with that.

Of course, people have been trading currencies for profit for many years prior to Mr. Soros hitting the headlines, however, the size and liquidity of the market in the primary currencies is largely the result of hedging activities by both financial and non-financial users of the markets and not speculative activity.  For the most part, currency trading has always been carried out on the inter-bank market, although there has been a huge amount of activity on the exchanges since the currency futures contracts were introduced in the late 1970s.  

I suppose it’s a matter of semantics, but any time that you don’t hedge a currency risk inherent in an investment position, or any other commercial position for that matter, you are speculating that the asset you have bought will increase in value both intrinsically and vis-à-vis the designated currency of that asset.

If a copper producer wished to hedge its future production, then it can sell copper forward by selling copper futures, but that transaction is, like most commercial hedges, an arbitrage between two similar assets - in this case, raw copper still in the ground or perhaps a yard full of unprocessed scrap, hedged by a forward copper sale on the LME, or COMEX.  However, if the objective is to hedge the currency risk within an investment – say a Euro investor who has bought US stocks - then that investor may decide to sell forward Dollars and buy forward Euros to the value of those US stocks.  Presumably, the Euro investor would originally have sold spot/cash Euros and bought Dollars to pay for the US stocks.  But my point is that, unlike most other hedging transactions, whatever happens, any transaction you do to hedge a currency results in an offsetting transaction in some other currency.

Excepting the most die hard anti-capitalists, I think it is fair to say that most people accept that, certainly in the futures and commodity markets, ‘speculators’ provide liquidity in the market.  It is often the case that speculators take the other side of the hedging transactions and thus provide the liquidity to the markets.  Nobody believes or would suggest that speculators do this for any altruistic reason - they do it because they believe they will make a profit.  It is a fact that, often hedgers lose money on their hedging positions but not always and that, of course, is compensated by a change in the value of their physical positions.  Thus, a commodity producer may, in addition to hedging his production on the London or US commodity markets, also enter into a currency hedging transaction in order to eliminate or mitigate the inherent currency risk that exists within those initial commodity hedging transactions.  For example, a European chocolate manufacturer may hedge his cocoa requirements for the next twelve months utilising the commodity markets, for the most part, hedging through a Dollar contract.  When the producer comes to buy the physical cocoa, he may well be doing that in Euros and therefore, will have to further hedge the currency risk between his Dollar denominated cocoa hedge and his Euro denominated physical transaction.  It is often the currency speculator that will take the other side of that Euro/Dollar hedging trade, but as I have already said, the speculator is not doing this for altruistic reasons, but in order to make a profit.  After all that is why investors buy stocks and hedge fund managers run long short-equity, merger arbitrage or convertible bond portfolios. 

In today’s economic environment, where economic chaos abounds in most of the world, sovereign debt risk has become a reality, Asia is booming and the BRIC nations are becoming the new economic powerhouses, fluctuations in the currency markets across the world have become a daily occurrence.  Furthermore, as various emerging markets throughout the world in Eastern Europe, Asia, Africa and South America develop, we are seeing increased activity and increased liquidity in what used to be called “minor” currencies.  Thirty years ago, few people would speculate in the Australian or New Zealand Dollar and the majority of emerging market currencies were subject to exchange control.  This has changed - not entirely, but to a very large extent - and now there is a growing market in trading in these “minor” currencies, because the markets are considerably more liquid than they used to be.

To get back to the original question, I cannot see why speculation or trading in currencies is any less acceptable than speculation or investing in any other asset or financial market.   Furthermore, when a Central Bank decides to enter the market in order to blatantly manipulate that market, either by buying their own currency in order to bolster it, or selling their own currency in order to depress it, is that speculation or investment?  If we accept one definition of speculation, which is “an investment that went wrong” and if we accept (my belief not based on any scientific fact or research) that most interventions by Central Banks end up losing money, then we can accept that most interventions by Central Banks are indeed speculations in their own right.  I would go further and suggest that they are a blatant and obvious - indeed, often declared - attempt to manipulate the market, which, if carried out by a hedge fund manager, would result in severely rapped knuckles at best, and possibly a political media inspired witch-hunt.  Gordon Brown’s sale of all or most of the UK gold reserves at what is close to the lows of the gold market in the last few years is a perfect example of government intervention that went wrong.

When considering speculation rationally, if that is possible, it is difficult to come to any other conclusion than all and any investment is speculation.  In my opinion, pension funds speculate every day by investing in stocks that they hope will generate a profit.  That is one of the definitions of both “speculation” and “investment” in the Oxford Shorter Dictionary.  The media and certain political commentators would have us believe that speculation is outright gambling and, as such, reprehensible.  I find it ironic that, if you go to a UK racecourse and have a bet with the Tote, you are advised that you have invested £5 or whatever sum your capitalist pocket permits - presumably a bet to win is a speculation whereas an each way bet is a hedged transaction.

As a final word, the headlines in the Financial Times today, as I write this, report that the IMF has warned that continued intervention by Central Banks (in this case, Japan) combined with the expectation that the second wave of Quantitative Easing is just around the corner will inevitably lead to high volatility in the currency markets, a view endorsed by the Central Bank of Brazil.  Although that may provide great trading opportunities and be manna from Hedge Fund Managers’ heaven, it is not their fault.  

Hedge funds make profits by identifying and taking advantage of inefficiencies in the markets, which are often exacerbated by high volatility.  Hedge fund activity will ultimately reduce or eliminate market inefficiencies - but, in this case, market instability or volatility results from the Central Bank’s intervention for the (their) “National Interest” is likely to continue to provide investment trading and speculative opportunities which hedge fund managers can and should take advantage of, in the interest of their investors.

My conclusion, therefore, is that currencies are not only an acceptable asset class for hedge funds, but today, are rather more interesting.

Dermot S. L. Butler