FX Volatility: Boon for Banks, Headache for Hedgers

By: Kevin Cook

Thursday's edition of Financial Times (what you read instead of The Journal) had a couple of good stories on FX volatility and the impact on both the banks who are making greater returns off of it and the corporations who are lowering earnings guidance because of it.
Peter Garnham's piece "Special FX: the asset class that thrives on volatility," highlighted the fact that despite investment bank woes overall, their currency trading desks are doing well as volatility has tripled in the major pairs and quintupled in many emerging market currencies. This dramatic rise in volatility is something I've been talking about in my weekly "FX Overnight" reports from the trading floor of the CME since September. 3-year average historical volatility for the majors has been around 10%, while the dramatic risk aversion that drove the U.S. dollar and Japanese yen higher in the H2 2008 shot vol up into the mid-20s.
Bank FX traders have profited nicely for several reasons. Wider bid/ask spreads are not only tolerated by customers but they are necessary for market makers to survive the daily volatility. And FX options desks are enjoying wider margins on their core business of risk premium marketing with implied volatility levels at 10 year highs.
Another angle I've been talking about is that although this credit crisis will go down in history as one of the worst, veteran FX traders recognize this period as similar to 1999 to 2002 when volatility also exploded. The common denominator for both periods is that interest rates between countries were converging.
The second FT article, "US company earnings hit by turbulence in currency markets" by Anuj Gangahar, pointed out Standard and Poor's estimate that nearly 50% of sales by S&P 500 companies came from outside the US in 2007 vs. 30% in 2001. The author goes on to highlight earnings shortfalls of as much as 5% due to currency fluctuations, primarily the stronger dollar in Q42008. Companies such as Proctor & Gamble, Mattel, Starbucks, McDonald's, and Wal-Mart all either took a hit last year or have warned about coming impact of FX moves.
As I said in my FX webinar last month, "Price Precedes Fundamentals," corporate hedgers aren't in the business of predicting currency moves but since they need to reduce their exposure to them, they tend to go with a policy of "hedge half and hope for the best because it offers the least amount of regret."

I will be doing a follow-up to that webinar this Saturday. Since I traded the interbank market for 10 years, I have a few things to say about the fundamentals and technicals the pros watch and use. But, as my title "Price Precedes Fundamentals" indicates, I favor the technicals because the fundies are just too hard to track and interpret most of the time. I'm not smart enough to keep up with big bank research desks and big-brain economists--who can't agree themselves anyway on a six-month forecast for the euro. That's why my subtitle is "How to Trade FX Even If You Don't Have a Degree in International Economics."
I don't argue with traders and economists about my thesis. It's not worth debating. Besides, the proof is everywhere that the market will defy the fundies longer than you can stay liquid, as the saying goes. So, I just wait for price to confirm the trend and sentiment change and say, "Okay, now the fundamentals are clearly driving price action, but the chart told me first, not my economics expertise--or lack thereof."

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