Currency Indexing: The Forward Rate Bias as an Alternative Beta

Although currency is often referred to as an asset class, the arguments to treat it as such have not been compelling enough to draw serious attention from the global institutional investor community. One possible reason for this is the absence of a universal view on the “beta” or market return available from currency investment.

One of the best-known styles of currency investment is the “carry trade” – investing in higher interest rate currencies, funded with lower interest rate currencies. This has been pursued as a trading strategy for many years, and has been widely-adopted by hedge funds and investment banks, but has yet to enter the mainstream institutional investment market. The source of returns from the carry trade, also known as “forward rate bias”, has been the subject of much academic study.

Recent research by Record Currency Management, a leading independent currency investment management firm, indicates that the forward rate bias (FRB) is in fact a currency risk premium that can be captured by investing in currency pairs in line with interest rate differences. Rather than simply being a trading strategy that is sometimes effective and sometimes not, the FRB is an intrinsic market return, and available to all investors who choose to exploit it, including through passive strategies. The FRB is therefore an “alternative beta”, or passively-available market return.

The FTSE Currency FRB5 Index, which was launched on 21 September 2009, captures this “alternative beta”. In doing so it will provide asset allocators, investors and managers with an independent index by which this return can be modelled, earned on a passive index-tracking basis, or which can be used to benchmark carry-based currency investment strategies. The FTSE Currency FRB5 Index is the first offering in the FTSE Currency FRB Index Series.

The forward rate bias

So what is the forward rate bias? Put simply, the FRB is the tendency of higher interest rate currencies’ total return to outperform that of lower interest rate currencies. This is not always seen – the FRB correctly anticipated whether investing in particular currency pairs would be profitable for 57% of monthly periods from June 1978 to July 2009, for each of the ten currency pairs comprised from US Dollar, Euro (Deutschemark pre-1999), Japanese Yen, Pound Sterling and Swiss Franc. Whilst far from certain, a 57% success rate is a strong basis for an investment proposition, particularly given the currency markets’ ever-present liquidity.

The proposal that the FRB is an alternative beta is based on analysis that demonstrates that the FRB is fundamentally driven by real (i.e. after-inflation) interest rate differences – i.e. higher real interest rate currencies outperform lower real interest rate currencies by at least the extent of the real interest rate difference in the long term.

Holding the higher real interest rate currency, funded by the lower real interest rate currency, would therefore allow an investor to capture this real interest rate difference over time.

Real interest rate differences are driven by fundamental differences in economies, which affect the risks attached to currencies, and hence the premium investors require to hold them.

Two key areas of difference within this developed market universe are inflation expectations and current account surpluses and deficits. More uncertainty about future inflation (or a Government’s inflation-fighting commitment), or about an economy’s ability to fund a deficit, will each require higher real interest rates (everything else being equal) and vice versa. Real interest rate differences persist because governments control short-term interest rates as part of monetary policy (which may include efforts to control inflation). Governmental control over short-term interest rates makes it unlikely that widespread investment in the forward rate bias would eliminate, or even reduce, the excess return.

The FTSE Currency FRB5 Index

If real interest rate differences are indeed the source of the FRB, then this return should be captured within any universe of currencies (as long as it’s not too small) by investing in all currency pairs in the universe, without selecting any, as long as all pairs are invested in line with rate differences – i.e. going long the higher rate currency against the lower, in each pair. The FTSE Currency FRB5 Index has been constructed to demonstrate this. The index is manager-independent, rules-based and transparent in its construction and its constituents, and as simple as possible, with as few rules and as little “engineering” as possible to capture accurately the FRB.

The FTSE Currency FRB5 Index invests in the five currencies for which spot and forward prices have been available since 1978, and which are also the most widely-traded currencies today: US Dollar, Euro (Deutschemark pre-1999), Japanese Yen, Pound Sterling and Swiss Franc. It is also calculated and available in five files – each denominated in one of these five currencies. The index assumes that at the start of each month, ten equally-weighted one-month forward contracts are entered into, representing all ten pairs that can be constructed from the five currencies. In each contract, the higher interest rate currency is bought against the lower.

At month-end, if the direction of the interest rate difference is unchanged, then the position is marked-to-market and rolled-over for another month. If the direction has reversed, then the forward contract expires (realising a gain or loss), and a new forward contract is entered into, with the direction reversed. The index is re-balanced monthly, and the month-end gain or loss is converted into the index’s base currency.

In all cases the timing of investment decisions has been set to be fully-replicable, and transaction costs have been included, to make the index investable. Third-party data from WM/Reuters has been used to construct the index, which starts at 30 December 1998, and an index history is available from 30 June 1978, based on Record’s data.

As well as being produced in all five base currencies, the index is available as both an excess return series (i.e. that from the currency programme alone), and a total return series – the total return series assumes cash equal to the size of the currency programme is invested from the outset of the series, and the cash return is included in the rebalancing of the currency programme.

The cumulative annualised excess return of the FTSE Currency FRB5 Index, expressed in US Dollars from July 1978 to December 2009, is 2.9% p.a. at a volatility of 5.8% p.a. (based on monthly returns), leading to an information ratio of 0.5. The equivalent figures for the total return index are a return of 9.6% p.a. at a volatility of 6.1% p.a.

The FTSE Currency FRB5 Index can be compared with returns generated from equities or bonds. The index since 1978 shows total returns similar to equities and better than bonds, at volatility similar to bonds and better than equities. Long-term correlations between the index and either equities or bonds are low. This combination of risk / return profile and low long-term correlations should make the FRB returns measured by the index a highly attractive component of optimised and diversified investment portfolios.

Firms which manage currency for return strategies (as opposed to currency hedging) and who wish to benchmark their active strategy can use the FTSE Currency FRB5 Index for pure performance measurement purposes. By the same token, the index is suitable as the basis for a passive index-tracking product.

What’s new about the FTSE Currency FRB5 Index?

There have been a number of previous attempts to establish currency carry “style indices”, frequently led by investment banks. We believe this new development builds on these indices in two important respects.

Firstly, from the perspective of index construction, we believe this index series is considerably simpler, with less investment “engineering”, than any of the existing offerings. Furthermore, the index is fully transparent and fully-costed (based on third-party data), down to making sure that every trade is undertaken on the correct side of the bid / offer spread, and properly recognising the need to allow time to make decisions based on one day’s set of prices, then investing in line with those decisions at the following day’s prices. The index can therefore be tracked perfectly, for any investor who can access the WM / Reuters prices on which they are based.

Secondly, and no less importantly, the research and analysis carried out by Record on the fundamental source of the return should give investors and their advisers comfort on its sustainability going forward. Whilst the FRB is widely recognised as a matter of fact, its source has been the subject of much debate. Record has addressed this by identifying differences in currency risk that fundamentally rely on a range of macroeconomic behaviour between countries. In the absence therefore of global economic harmonisation and convergence, we believe this range of behaviour will continue to exist, and to appear in the FRB.

These two topics are related in that this index seeks to capture the underlying return, or “alternative beta”, from an FRB strategy in as simple a fashion as possible. Existing carry “style indices” all involve some measure of investment engineering, and hence better represent particular processes intended to improve on this beta return. While we’re not looking to challenge the merits of any of these processes, we believe none of them qualifies as an alternative beta in the way the FTSE Currency FRB5 Index does.

Conclusions

The “forward rate bias” is driven by economic differences and governmental control over short-term interest rates and is a persistent source of structural excess returns in the currency markets. We have developed a manager-independent, rules-based and transparent index for the FRB to measure and exploit this return.

The index generates an equity-like return at bond-like volatility, and low correlations with either; taken together with the scalability inherent in the currency markets, and the universe of established managers, this should help the investment community recognise the currency FRB as an “alternative beta”.

--Carl Beckley, James Wood-Collins, and Mike Bruno