The Foreign Exchange Matrix. Barbara Rockefeller

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СКАЧАТЬ is negative, then it means that buying insurance to protect against a currency move lower is more expensive than buying insurance to protect against a currency move higher. When risk reversals hit extended levels, it may indicate that a directional expectation has become excessive.

      “This bias helps in assessing the excessive sentiment toward a directional preference and the common wisdom is to use it as a contrarian indicator,” explains Bashar Azzouz, Founder and Managing Director of 2 Rivers Consulting. Azzouz, who manages money and educates on option strategies, says the common practice is to generate two sets of observations from positive and negative risk reversals. The upper limit will be the mean (pick a historical time frame such as six months or a year) of the positive observations, plus one standard deviation of the positive observation. If the upper limit is exceeded, then the bias indicates excessive bullishness and therefore can be viewed as overbought. The lower limit will be the mean of the negative observations, minus one standard deviation of the negative observations. If the lower limit is exceeded, then the bias is indicating excessive bearishness and can be deemed oversold.

      Risk reversals and their ranges can vary greatly between FX pairs. These instruments are quoted like forward foreign currency swap rates, typically from one week to one year, with the most attention paid to the one-month risk reversal. There are occasions where one period suggests future bullishness and another future bearishness. “When there is a divergence in the skew, say one-month (risk reversals) shows calls are bid over puts, while three-months shows puts are bid over calls, this may indicate a corrective short-term bullish outlook in a longer-term bearish trend,” Azzouz suggests.

      3. Federal Reserve stress indexes

      Currency traders seeking a more detailed picture look beyond the one dimensionality of the CBOE’s VIX and seek out other risk indicators that factor in multiple variables, such as Federal Reserve stress indexes. The Federal Reserve Banks of Kansas City and Cleveland release monthly Financial Stress Indexes (FSIs) and the Federal Reserve Bank of St. Louis releases a weekly Financial Stress Index (FSI). These Fed risk gauges are becoming more popular as FX tools. With all stress indicators, the higher the stress, the more pro-dollar bias we see in the FX market.

      Kansas City Federal Reserve Financial Stress Index (KCFSI)

      The Kansas City Federal Reserve Bank describes its FSI as “a monthly measure of stress in the US financial system based on 11 financial market variables.” These variables are: the three-month LIBOR/T-Bill spread (TED spread), the two-year swap spread, off-the run/on the run 10-year Treasury spread, Aaa/10-year Treasury spread, Baa/Aaa spread, high-yield bond/Baa spread, consumer ABS/5-year Treasury spread, the negative value of correlation between stock and Treasury returns, the implied volatility of overall stock prices (VIX), idiosyncratic volatility (IVOL) of bank stock prices, and a cross-section dispersion (CSD) of bank stock returns. “A positive value indicates that financial stress is above the long-run average, while a negative value signifies that financial stress is below the long-run average.” ^[6]

      The Kansas City Fed explains the root causes of financial stress as arising from:

       increased uncertainty about fundamental value of assets

       increased uncertainty about behaviour of other investors

       increased asymmetry of information

       decreased willingness to hold risky assets (flight to quality)

       decreased willingness to hold illiquid assets (flight to liquidity)

      In discussing the uncertainty about the fundamental value of assets, the Kansas City Fed observed that financial innovations can “make it difficult for lenders and investors to even assign probabilities to different outcomes. This kind of uncertainty, in which risk is viewed as unknown and unmeasurable, is often referred to as Knightian uncertainty.” As example of financial innovation, the Fed pointed to “complex structured products such as collateralised debt obligations (CDOs) in the recent subprime crisis, or program trading in the Long-Term Capital Management crisis of 1998.”

      On the issue of transparency the Kansas City Fed stated, “asymmetry of information is said to exist when borrowers know more about their true financial condition than lenders, or when sellers know more about the true quality of the assets they hold than buyers.” These information gaps can “lead to problems of adverse selection or moral hazard, boosting the average cost of borrowing for firms and households, and reducing the average price of assets on secondary markets.”

      In the past 15 years, the KCFSI flashed warning signals on several occasions. See Figure 2.4. In the period from October 1998 to October 2002, the KCFSI saw six distinct peaks in a short period of time. The index peaked in the wake of the Russian debt moratorium in August 1998 and the bailout of Long-Term Capital Management in September 1998, and then peaked in October 1999 ahead of Y2K.

      Figure 2.4 – Kansas City Fed Stress Index (monthly)

      Source: research.stlouisfed.org/fred2

      In 2000, the KCFSI peaked twice, first in line with the bursting of the technology bubble and subsequent sharp NASDAQ Composite decline and then again later in the year. “The second peak was December 2000, when there were no obvious reasons for increased financial stress other than the approach of recession. The next peak came after the 9/11 attacks and the most recent peak came in October 2002, amidst widespread accounting scandals (Enron/World Com).

      During the subprime crisis, the KCFSI has spiked on a few occasions, first in response to mortgage-related concerns in August and November 2007, and then again in March 2008, when Bear Stearns collapsed. Later in July 2008, the index again spiked when IndyMac failed and Fannie Mae and Freddie Mac had their issues. The following year saw the largest spikes seen ever in the index, first in September 2008, following the Lehman Brothers bankruptcy, AIG bailout, and forced merger of some institutions (such as Bank of America and Merrill Lynch). The index spiked again in October 2008 amidst debate about the $700 billion Troubled Asset Relief Program (TARP).

      To give a sense of magnitude of the moves, the Kansas City Financial Stress Index peaked at 5.57 in October 2008 (after Lehman Brothers bankruptcy and around the TARP debate) and remained elevated (at 4.68) at year-end. In the first quarter of 2009, despite wider deleveraging of positions in equities and commodities, the index edged lower (3.99 in March). By August 2009, the KCFSI had dipped below 1.0 and has remained below there ever since, even slipping into negative territory on several occasions in 2010, 2011 and 2012.

      St. Louis Federal Reserve Financial Stress Index (STLFSI)

      The St. Louis Federal Reserve’s Financial Stress Index (STLFSI) is similar to the KCFSI, but with 18 variables. It is updated weekly on a Thursday at 10 am Central Standard Time. ^[7] The STLFSI takes into account interest rates (the effective fed funds rate and two, ten, and 30-year Treasury yields, Baa-rate corporate yields, Merrill Lynch High-yield Corporate Master II index, Merrill Lynch Asset-Backed Master BBB rated rates), yield spreads 10-year Treasury minus 3-month Treasury yield curve, Corporate Baa-rated bond minus 10-year Treasury, Merrill Lynch High Yield Corporate Master II index minus 10-year Treasuries, 3-month London Interbank Offering Rate-Overnight Index Swap (LIBOR-OIS) spread, 3-month Treasury-Eurodollar (TED) spread, 3-month commercial paper minus 3-month Treasury bill, and other indicators including the JP Morgan Emerging Markets Bond Index Plus, the CBOE’s volatility index VIX, Merrill Lynch Bond Market Volatility Index (1-month), 10-year nominal Treasury minus 10-year Treasury Inflation Protected СКАЧАТЬ