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Inefficient FX markets offer an opportunity

Kathleen Brooks
THE currency market is the most liquid in the world. Turnover tops $3.1 trillion a day, which dwarves both the equity and bond markets. Given the ubiquity of currency trading, it’s easy to assume that the FX markets would be efficient.

But that is not the case. American Century Investments, an investment management firm, believes that currency markets are inefficient because they are populated by a majority of “passive investors” – for example multi-national corporations who need to hedge currency risk, or central banks which require liquidity in various currencies. This is in contrast to equity and bond markets, which are traditionally considered deeply efficient.

Efficient markets have certain characteristics: participants tend to be homogenous and in the market for the same reason, rational – everyone uses the same models to trade – and risk neutral, because everyone concentrates on return not risk. Instead, American Century Investments cites an academic study titled Under the Microscope: “The Structure of Foreign Exchange Markets”, by Michael Sanger and Mark Taylor, which uses evidence to show that foreign exchange markets do not exhibit these characteristics and are therefore not efficient: “The currency market incorporates a heterogeneous set of participants…with different reaction speeds…and diverse opportunity sets and risk-return expectations.”

But what does this offer traders who are willing to speculate on the forex markets? Firstly, there is evidence to suggest that there is excess return potential – the return less the risk-free rate and management fees – for active investors who want to make profits. The Deutsche Bank Currency Returns Index, which measures the performance of the most widely used investment strategies among active currency managers, has produced an annualised rate of excess return of 3.6 per cent from January 1990 to March 2010. Likewise, the Barclays Capital Currency Traders Index also shows that foreign exchange can deliver the goods: since its inception in 1985 the index has delivered a total return of 7.7 per cent per year.

Secondly, foreign exchange markets offer diversification benefits and should be considered an alternative asset class in the same way as hedge funds and private equity. American Century Investments has found that from 1994-2010 currencies have stood out as the alternative asset class with the lowest correlation to both US equities (see chart below) and global equities. “In sum, during the recent global financial crisis (and previous financial crises as well) currencies as an asset class did a better job than most other alternative asset classes in providing diversification benefits when combined with traditional asset classes.”

Unlike other markets, during the peak of the credit crunch the currency markets did not seize up. For these reasons, professional investors should consider currency markets as an asset class all of their own.