Innovative Ideas in Currency Management

October 2005

2

Evolution of Currency Management

• Currency mandates

– Hedging (late 1980s; mid 1990s); Pure alpha (late 1990s; current)

– Absolute return (early 2000s)

– Cash play – use innovative FX programs to fill cash flow gap

• Currency managers

– Single style using only forwards in EAFE markets (to late 1990s)

– Multi-style using forwards, options, developed and emerging

• Currency clients

– Passive benchmark to managing their own strategic currency risk

3

Philosophy: An Untapped Alpha Opportunity!

Corporate TreasurersCorporate Treasurers(Insure foreign profits)(Insure foreign profits)

Central BanksCentral Banks(Increase employment, (Increase employment,

lower inflation)lower inflation)

International Bond and Equity International Bond and Equity ManagersManagers

(Need to buy currency to buy (Need to buy currency to buy foreign assets)foreign assets)

Currency Currency MarketMarket

Many participants have non-profit motives Many participants have non-profit motives

IndividualsIndividuals(Tourism)(Tourism)

4

Impact of Diversification – Opportunities and MarketsDeveloped Developed

MarketsMarkets

AddAdd

Options Options (Developed)(Developed)

AddAdd

Emerging Emerging MarketsMarkets

All ThreeAll Three

Number of Number of TransactionsTransactions

Maximum 10

Additional 20Additional 20 Currencies

Average 40

Net ReturnNet Return

(for 12% (for 12% volatility)volatility)

7% 10% 17% 17%

Return/Risk Return/Risk RatioRatio

0.5 – 0.8 0.8 – 1.0 1.0 – 1.5 1.5

Cannot use overlay models/approach in this absolute return paradigm Cannot use overlay models/approach in this absolute return paradigm

5

Market Inefficiency = Simple Rules Make Money

• Three simple rules make money in currencies.

1. Currency markets trend.

Buy the currency that went up last month.

2. Currencies with high interest rates will appreciate

vs. currencies with low interest rates. Buy high interest rate currencies.

3. Options tend to be overpriced. Sell options.

6

Performance of JPY Rules/Strategies

• Rules Evaluated: (a) yield curve; (b) carry; (c) moving average

• USD/JPY Strategy = 40% Yield curve and Carry, 20% MA

• Diversification improves information ratio, skill, & drawdown

Strategy/ Rules

Annualized Return

Annualized Std Deviation

Information Ratio

Cumulative Return

Confidence in Skill

Success Ratio

Ratio Good /Bad Risk

Max Drawdown

USD/JPY Strategy 4.59% 8.56% 0.5365 57.45% 94.17% 52.86% 0.9103 -20.45% USD/JPY Yield Curve 4.54% 11.59% 0.3919 56.68% 85.59% 53.43% 0.8564 -26.21% USD/JPY Carry 4.33% 11.59% 0.3741 53.57% 84.26% 52.37% 0.8613 -26.21% USD/JPY MA 20-65 3.62% 11.59% 0.3121 43.22% 79.05% 51.12% 1.06 -20.51%

Source: AlphaEngineTM, Mcube Investment Technologies, LLC

www.mcubeit.com (purely hypothetical example for educational purpose only)

7

Performance of EUR Rules/Strategies

• Rules Evaluated: (a) yield curve; (b) carry; (c) moving average

• USD/EUR Strategy = 40% Yield curve and Carry, 20% MA

• Trend model losses are meaningful; but moderate lower drawdown and worst single performance of the strategy

Strategy/ Rules

Annualized Return

Annualized Std Deviation

Information Ratio

Cumulative Return

Confidence in Skill

Success Ratio

Ratio Good /Bad Risk

Max Drawdown

USD/EUR Strategy 3.79% 5.09% 0.7444 45.69% 98.89% 55.21% 0.9793 -7.78% USD/EUR Yield Curve 5.20% 6.26% 0.8301 40.10% 98.42% 82.95% 0.8599 -8.08% USD/EUR Carry 8.48% 9.71% 0.8729 127.66% 99.56% 55.21% 0.8997 -13.07% USD/EUR MA 20-65 -5.22% 9.72% -0.5372 -41.86% 3.13% 46.68% 1.1392 -49.12%

Source: AlphaEngineTM, Mcube Investment Technologies, LLC

www.mcubeit.com (purely hypothetical example for educational purpose only)

8Return calculated versus a 0% hedged position

EUR HEDGE RATIO

0%

20%

40%

60%

80%

100%

120%

Date

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96

98

100

102

104

106

108

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Do Nothing

Partially Hedge

Fully Hedge

% o

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Gro

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of a

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9

Innovative Approaches for Clients

• Can generate meaningful cash, without funding, and with a specific dollar loss limit (easiest constraint to monitor)

• Can be delivered through a managed account or even total return swap

• Clients can also manage their own strategic decisions – biggest impact on performance

• Trend to move away from traditional approaches and markets