Chapter 5: Mean Reversion of Currencies and Futures WILLIAM LAI Outline • Introduction • Trading Cross Rates • Rollover Interests • Trading Futures Calendar Spread • Futures Intermarket Spreads • Comments Introduction • Currency Pairs • Spot • Futures/Forwards • Options • Exotics • Mostly no cointegration or mean reversion in currency pairs • Some exceptions, but rare or difficult to capitalize on (e.g. non-deliverable forwards or onshore-offshore currency pairs). • Quoting convention: Base/Quote (e.g. EUR/USD, GBP/USD, USD/JPY, USD/CHF) Trading Cross Rates • Cross Rates • B/Q2 vs. B/Q2, creating a synthetic pair • In theory, price should match actual pair (not necessarily true in practice) • Use a Johansen test to determine optimal hedge ratio (weightings) for the pairs • Cointegration test for more general VAR(p) models using VECM • Noted in the chapter to be the eigenvalue-version of the Johansen test • Apply mean reversion strategies similar to the ones described in Chapter 3 • Buying or selling when deviating sufficiently from trend • Can specify lookback period, weighting over the lookback period, movement thresholds, alternative hedge ratio determinations, additional filters, etc. Rollover Interests • Spot transactions (usually) settle at T+2, so holding an open spot position overnight actually entails extending it by rolling • This is because most FX trades involve borrowing the currency to be sold • Holding overnight or longer requires interest on such borrowings • This involves the interest rate differential between O/N rates on the base and quote currencies • If the interest rate on the borrowed currency is higher, then you pay rollover interest. You earn rollover interest if the opposite is true • Often, this borrowing takes place through FX Swaps (e.g. USD/TRY and Turkey’s FX Swap restrictions during Summer 2018) Trading Futures Calendar Spreads • Trading pairs of futures with different tenors (maturities) • Backwardation • Futures price is below the expected spot price • Contango • Futures price is above the expected spot price • Contango more common due to carry costs • These terms are used more for commodities and not FX futures • FX futures are priced on a carry model at a discount/premium to spot Futures Pricing (Simple) • Back to the Calendar Spreads • Trading Intermarket Spreads • Identifying futures with different underlying assets that cointegrate or have a mean reverting combination • Difficult for simple commodities futures • Turn to further derivatives as an alternative • VIX futures vs. Equity market futures (some cointegration shown in the chapter) • Some possibilities: USD/BRL onshore forwards vs. offshore NDFs (may have a stable long-term relationship that deviates in times of high market uncertainty), Sovereign CDS vs. Sovereign Bond Yields or Z- spreads, VIX Futures vs. FX Options (straddles), etc. Comments • Even if FX markets are perceived as more efficient, sentiment and strategy still play their roles • Especially true in emerging markets • Knowledge of automatic take-profits and stop losses allows for hard evidence to back technical trading • Trading on cointegration or mean reversion seems related to being long volatility • Relies on large enough deviations from trend to generate worthwhile opportunities • Pays transaction costs to trade in exchange • Interesting to look at relationships between other fixed-income instruments (e.g. Options, sovereign bonds, sovereign CDS, etc.) • Consider execution costs and hedging costs/methods (CCY basis, FX Swaps, CCY Swaps, etc.).