Central Bank Hike In Interest

Size of assets plays a role in deciding when to add exotics. Carat Capital in New York plans to introduce foreign currency exchange rate chart trading by the end of 2007, coinciding with the growth of money under management. Carat, which manages $ 30 million, found that the excess positive return earned per unit of risk (a calculation similar to the Sharpe ratio) actually is higher for the exotics than for major currencies already in the portfolio.

But Carat's allocation will be relatively small, about one-third to half of the allocation to a major currency, such as the Japanese yen. Because liquidity is a must for Carat or any CTA, Carat will start with Southeast Asian currencies that have a considerable following, such as the Malaysia ringgit, Indonesia rupiah and Thai baht.

Defense program The principal of Currency Management Inc. in Rockville, Md., says instead of using the exotics as a profit maker, he uses them for risk management. His strategy, which is instigated when a country finds its currency under attack and facing devaluation has been used on the Mexico peso, Thailand baht and Korea won. The central defense strategy reduces cost of devaluation and can turn a profit.

Assume a client in Korea who is a Korean won earning corporation with U.S. dollar-denominated debt, which means its foreign exchange risk is long won/short U.S. dollars. If the won is weakening and in jeopardy of devaluing more in the future, the corporation has two problems: 1) it has monthly U.S. dollar interest payments to make on its debt and now requires more won to buy the dollars; and 2) because interest rates will be increased dramatically by the Korean central bank to defend its currency, selling the won forward in a traditional hedge is too expensive.

So to take advantage of the central bank's hike in short-term interest rates, which, over time, will appreciate at a greater rate than the won will depreciate, Burlbaugh arranges for the client an interest-earning Korean won deposit account and a U.S. dollar/Libor line of credit. The won account serves as collateral for the U.S./Libor line of credit. Because the interest earned on the won will grow faster than the won depreciates, the client can use the difference, or extra won, to pay the U.S. dollar debt. Burlbaugh's strategy applied to the Mexican peso at the height of its currency crisis earned back 45% devaluation of the peso within 14 months and created profits of 12% within two years.

Location matters It's no secret most currency traders choose the interbank over the exchange. Besides the obvious advantages of liquidity, volume and 24-hour access, the absence of pre-determined contract size is another plus. Instead of being confined to a round number of contracts, the trader can execute a specific dollar amount. On the other hand, because the interbank deals in substantial transactions - $ 1 million as a rough minimum - CTAS with lower funds are forced to trade on the exchange.