Risk Instability Indicators and Exchange Rates- Valutrics

The private sector has over the past few years been hard at work creating “risk appetite indicators” to measure overall conditions for risk tolerance across currency and asset markets.
Within the investment banks, JPMorgan created its “LCPIIndex” Bank of America has its“GlobalHazard
Indicator” and Salomon Smith Barney its “Instability Index”. For the purpose of an example,
we will focus on the Instability Index. The index was originally created to track levels of risk
appetite or conversely “instability” for fixed income investors. However, because it uses cross-
market indicators for this purpose, we can also use it for managing and trading currency risk.
Risk appetite has become an increasingly important concept, not just because of the need
to create more accurate models for forecasting short-term currency moves, but also because
the last few years have shown a marked pick-up in cross-asset market volatility. Indeed, one
can go as far as to suggest that as the globalization of capital flows has proceeded, so volatility
has increased. Risk appetite is essentially a capital flow event and its relationship is directly
proportional to the size of capital flows involved.For this very reason,just as capital flows across
borders have grown exponentially,so the degree to which capital flows affect currency markets
has grown proportionately. A crisis in one country is no longer isolated but is transmitted
instantly around the global financial system. Investors who face losses in that one market may
seek to take profit on other positions in order to offset those losses, thus creating a domino
effect in hitherto unrelated markets.

When market conditions are perceived as stable according to the market indicators used by the
index, they are of necessity optimum for investors to be in risk-seeking mode. Equally, when
market conditions are unstable, this is synonymous with investor risk-aversion or avoidance.
The focus for such an analytical tool has been the investor community. However, currency
speculators and corporations can also use a risk appetite or instability indicator with which to
trade or manage their currency risk.

There is actual fundamental grounding for using a risk appetite indicator for currency hedg-
ing, trading or investing. Since the end of the Cold War, there has been much greater emphasis
on tightening fiscal and monetary policies in order to bring inflation down. As a result, real
interest rates have been rising. In the developed markets, capital flows over the medium to
long term to those currencies with high real rates. The discipline associated with membership
of the EU and the Euro has exacerbated this process, and the same should happen in Central
and Eastern Europe ahead of accession to the EU. As a result of such global macroeconomic
forces, the trend has been to hold high carry currencies in all conditions – risk-seeking/stable
and neutral – apart from risk-aversion/unstable.
The link between risk appetite or instability and currencies comes through capital flows and
therefore through the balance of payments. Countries with high current account deficits are
dependent on capital flows and therefore dependent on high levels of risk appetite. Conversely,
countries with current account surpluses are not dependent on capital flows or risk appetite.

Therefore, during periods of risk-seeking, it should be no surprise that currencies whose
countries have current account deficits tend to outperform. Equally, during periods of risk
aversion or avoidance, currencies whose countries have current account surpluses tend to
outperform by default as capital flows are reduced or even reversed.
In the developed economies,currencies such as the US dollar,UK pound sterling,Australian
dollar and New Zealand dollar are seen as risk-dependent currencies because of their current
account deficits. Conversely, currencies such as the Swiss franc and the Japanese yen are not
dependent on risk appetite because they have current account surpluses and therefore are seen
as “safe havens” in times of risk-aversion. This is not an exact science, because there are
exceptions such as the Canadian dollar, which tends to prosper during periods of risk-seeking
despite the fact that Canada has historically run current account surpluses.Generally,however,
within the developed economies the relationship between risk appetite and the current account
tends to hold.
The principles that we have described here work for the developed market currencies. They
also work very well within emerging market currencies, albeit with some caveats. Emerg-
ing market economies and currencies have some specific characteristics which need to be
considered when using a risk appetite or instability indicator:
rMost emerging market economies have current account deficits–Because of high capital
inflows, most emerging market economies run trade and current account deficits.As a result,
most are risk-dependent, though one would assume this anyway.
rEmerging market economies tend to have structurally high levels of inflation – Due to
economic inefficiencies and higher growth levels, emerging market economies have tended
to be characterized by higher inflation levels.
rEmerging market interest rates are more volatile – Capital inflows to the emerging
markets are frequently substantially larger than the ability to absorb them without consequent
major financial and economic imbalances. Such inflows artificially depress market interest
rates until such time as economic imbalances become unsustainable, at which point the
currency collapses and interest rates rise sharply. Thus, such inflows can cause substantial
interest rate volatility.
rPolitical, liquidity and convertibility risk add to emerging market volatility – Politics
is no longer seen as a primary risk consideration within the developed markets, but it still is
within the emerging markets however, given higher levels of political instability. Emerging
markets are also considerably less liquid and some are not convertible on the capital account,
both of which affect market pricing.
These caveats notwithstanding, asset managers, leveraged investors or corporations can use
a risk appetite instability indicator as a benchmark for managing or trading emerging market
as well as developed market currency risk. High carry currencies such as the Polish zloty,
Hungarian forint, Brazilian real and Mexican peso tend to outperform when market risk
appetite conditions are in risk-seeking/stable mode, while equally under-performing when market
conditions are in risk-aversion/unstable mode. Similarly, low carry emerging market currencies
such as the Singapore dollar and the Czech koruna tend to underperform during periods of
risk-seeking/stable market conditions and outperform during periods of risk-aversion/unstable
market conditions.