Chapter 5: Mean Reversion of Currencies and FuturesWILLIAM LAI

Outline

• Introduction

• Trading Cross Rates

• Rollover Interests

• Trading Futures Calendar Spread

• Futures Intermarket Spreads

• Comments

Introduction

• Currency Pairs • Spot • Futures/Forwards • Options • Exotics

• Mostly no cointegration or mean reversion in currency pairs • Some exceptions, but rare or difficult to capitalize on (e.g.

non-deliverable forwards or onshore-offshore currency pairs). • Quoting convention: Base/Quote (e.g. EUR/USD, GBP/USD,

USD/JPY, USD/CHF)

Trading Cross Rates

• Cross Rates • B/Q2 vs. B/Q2, creating a synthetic pair • In theory, price should match actual pair (not necessarily true in practice)

• Use a Johansen test to determine optimal hedge ratio (weightings) for the pairs • Cointegration test for more general VAR(p) models using VECM • Noted in the chapter to be the eigenvalue-version of the Johansen test

• Apply mean reversion strategies similar to the ones described in Chapter 3 • Buying or selling when deviating sufficiently from trend • Can specify lookback period, weighting over the lookback period, movement

thresholds, alternative hedge ratio determinations, additional filters, etc.

Rollover Interests

• Spot transactions (usually) settle at T+2, so holding an open spot position overnight actually entails extending it by rolling • This is because most FX trades involve borrowing the currency to be sold

• Holding overnight or longer requires interest on such borrowings

• This involves the interest rate differential between O/N rates on the base and quote currencies

• If the interest rate on the borrowed currency is higher, then you pay rollover interest. You earn rollover interest if the opposite is true

• Often, this borrowing takes place through FX Swaps (e.g. USD/TRY and Turkey’s FX Swap restrictions during Summer 2018)

Trading Futures Calendar Spreads

• Trading pairs of futures with different tenors (maturities) • Backwardation

• Futures price is below the expected spot price

• Contango • Futures price is above the expected spot price

• Contango more common due to carry costs • These terms are used more for commodities and not FX futures • FX futures are priced on a carry model at a discount/premium

to spot

Futures Pricing (Simple)•  

Back to the Calendar Spreads

•  

Trading Intermarket Spreads

• Identifying futures with different underlying assets that cointegrate or have a mean reverting combination

• Difficult for simple commodities futures

• Turn to further derivatives as an alternative • VIX futures vs. Equity market futures (some cointegration shown in

the chapter) • Some possibilities: USD/BRL onshore forwards vs. offshore NDFs (may

have a stable long-term relationship that deviates in times of high market uncertainty), Sovereign CDS vs. Sovereign Bond Yields or Z-spreads, VIX Futures vs. FX Options (straddles), etc.

Comments• Even if FX markets are perceived as more efficient, sentiment and

strategy still play their roles • Especially true in emerging markets • Knowledge of automatic take-profits and stop losses allows for hard

evidence to back technical trading

• Trading on cointegration or mean reversion seems related to being long volatility • Relies on large enough deviations from trend to generate worthwhile

opportunities • Pays transaction costs to trade in exchange

• Interesting to look at relationships between other fixed-income instruments (e.g. Options, sovereign bonds, sovereign CDS, etc.)

• Consider execution costs and hedging costs/methods (CCY basis, FX Swaps, CCY Swaps, etc.)