The Foreign Exchange Matrix - Barbara Rockefeller

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reasonable-sounding scenario is that economies that are already vulnerable – due to trade and budget deficits, stressed institutions, inadequate legal and regulatory institutions, etc. – will be affected the most by a shock. These are the countries that sophisticated and knowledgeable investors will exit first. But that doesn’t account for the major markets in advanced countries following the Shanghai stock index. It also doesn’t account for a shock in one asset class in one country affecting different asset classes in other countries that are linked only in the most indirect ways. Something else is going on.

      The something else is perception of riskiness in the world at large, and perception of riskiness is heavily influenced by what academics call information asymmetry. At a basic level, if one party to a transaction has more information than the other party, the informed party has more power and will likely be the profitable one. Think of inside information, moral hazard and why governments impose disclosure rules on minimum safety conditions in real estate.

      Information asymmetry is illustrated perfectly in every home sale – the seller knows the furnace is on its last legs, the roof will need replacement in two years, and there is some asbestos lurking in the cellar ceiling. The selling agent may or may not know these things, and the buyer certainly doesn’t know them and will not be told them unless the law requires disclosure of each specific drawback by name. The buyer is at risk of overpaying for the house, and cannot count on the agent to volunteer adverse information because the agent works for the seller.

      In the home sale case, the seller is more knowledgeable about the asset than the buyer. In the case of financial market information asymmetry, emerging market investors generally tend to have less information than advanced country investors about emerging markets overall, including their home market. The foreign investors tend to have more news sources, including sources that may not be permitted in the emerging market itself. In fact, sometimes the flow of adverse information runs from one emerging market through the advanced investors to a second emerging market before the domestic investors in the original emerging market catch on. That’s just one example of how a lopsided flow of information can move.

      In market contagion, the less-knowledgeable party knows that he is less knowledgeable and fears being cheated, so that he sells even when there is no evidence that the quality of the asset has changed. When an investor knows he is less-knowledgeable, he assumes the more-knowledgeable parties have information he does not have, so he joins the stampede. Thus, when the presumed knowledgeable parties started a sell-off in overvalued Thai equities, it spread to other risky assets elsewhere in Asia and then Argentina and Russia, even though Malaysians, for example, complained it was unfair to be tarred with the Thai brush.

      In many instances, the domestic investors were authentically more knowledgeable about their home assets and knew perfectly well that there was, objectively, no change in the conditions that should determine their prices – except that advanced country investors were fleeing emerging markets indiscriminately (in what investment managers term cross-market rebalancing). By assuming that emerging markets share the same market and economic risks to the same degree, the managers can transmit contagion in the form of falling prices even in the absence of directly relevant news, and sometimes between markets that do not, in fact, share the same risks.

      It can work the other way around, too, like the home seller failing to disclose asbestos in the cellar ceiling. Unscrupulous asset sellers can offer fraudulent products, like some Chinese companies listed on the New York Stock Exchange and other exchanges, that are the paper equivalent of knock-off Rolex watches and Hermes scarves. The buyers who know they are less-knowledgeable about the true financial condition of these companies are the first to exit on news of a regulatory investigation.

      The second important point is that information flow and thus market effects are not linear – they ricochet around in the pinball motion mentioned in Chapter 1. Sometimes contagion can occur in the absence of information and is based on unfounded assumptions. [5] Therefore, what traders and investors need is a general indicator of global riskiness. If global riskiness is low, the probability of a shock in a small context becoming a major crisis is also low. If the market feels riskiness is high, the slightest rumble can set off shock waves, and perhaps in some asset classes linked to the source by many degrees of separation.

      Unfortunately, we do not yet have a single index of global riskiness that works in all instances. But we do have a selection of indicators and indices that send out warning sounds ahead of shocks that cause global stock markets to plummet and safe-haven buying of developed market bonds.

       Let’s look at these now.

      Risk gauges

      There are a selection of indictors that can be used to assess risk in financial markets. Many of these are based on markets or areas other than FX, but conclusions can be extrapolated from these to the FX market. These risk gauges give FX traders reliable guidance towards direction, but not necessarily about the magnitude of moves. Traders use these risk gauges mostly to red flag potential trend changes.

      These indicators are:

      1 The VIX

      2 Risk reversals

      3 Federal Reserve stress indexes

      4 Bank stress indexes

      5 Inflation breakevens and inflation swaps

      6 Corporate spreads/credit default swaps

      7 Prices of commodities

      1. The VIX

      One of the most closely tracked risk instruments is the Chicago Board Option Exchange’s (CBOE’s) volatility index or VIX (also called the fear factor). The CBOE describes the VIX as “an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500 Index (SPX) option bid/ask quotes.” It is seen as a proven risk gauge.

      To calculate the VIX, the CBOE uses “near-term and next-term out-of-the money SPX options with at least eight days left to expiration, and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.” While the VIX is quoted as a percentage, most analysts drop the percentage sign and just use the number itself. When the VIX price goes up, it means risk aversion is kicking in and the S&P 500 typically falls. Conversely, when the VIX falls, there is more risk appetite in the market and the S&P usually will rise. A graph of the S&P 500 juxtaposed over the graph of the VIX would provide roughly a mirror image of the risk indicator. See Figure 2.2.

      Figure 2.2 – VIX and S&P 500 (inverted scale, monthly)

      As well as VIX, the CBOE calculates other volatility indexes including the NASDAQ-100 Volatility index (VXN) and the DJIA Volatility Index (VXD). In 2008, the CBOE introduced other indexes incorporating VIX methodology. These new contracts include the Crude Oil Volatility Index (OVX), the Gold Volatility Index (GVZ) and the EuroCurrency Volatility Index (EVZ), all of which use exchange-traded options based on the United States Oil Fund LP(USO), SPDR Gold Shares (GLD) and CurrencyShares Euro Trust (FXE), respectively. While traders may occasionally use these other tools, the focus remains on the VIX and the latest signal that the fear factor is emitting.

      A VIX level below 20 is deemed positive for risk and a VIX level over 40 is deemed negative for risk, with the range in the middle deemed indecisive. A timeline of the VIX shows that after starting the millennium around 24.15, the index soared to a high of 43.74 in the wake of the 9/11 attacks and then slipped back into the 20s and 30s in 2002/2003. The VIX stood at 29.15 at the start of the Iraq War in March 2003, before closing the year at 18.31. At the time of Hurricane Katrina in August 2005, the VIX was trading below 15.

      The index remained offered in subsequent years, with the low volatility indicative of the extreme risk appetite present in the market. The VIX bottomed at a 13-year low of 9.39 in December 2006, very close to the life-time low of 9.31 seen in 1993. By October 2008, at the peak of the US financial

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