From everything-claude-trading
- Analyzing currency valuation using fundamental models (PPP, interest rate parity, balance of payments)
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- Analyzing currency valuation using fundamental models (PPP, interest rate parity, balance of payments)
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Absolute PPP:
Relative PPP:
PPP-Based Valuation:
OECD PPP estimates provide fair value benchmarks:
- If spot rate is 20%+ above PPP: currency is overvalued
- If spot rate is 20%+ below PPP: currency is undervalued
Example: If EUR/USD PPP = 1.30 and spot = 1.08
- EUR is 17% undervalued vs USD on PPP basis
- Suggests long-term EUR appreciation potential
- But PPP convergence can take years; not a timing tool
Covered Interest Rate Parity (CIP):
F/S = (1 + r_domestic) / (1 + r_foreign)
Where F = forward rate, S = spot rate
Forward premium/discount reflects interest rate differential
In practice: CIP holds tightly due to arbitrage
Post-2008 exception: cross-currency basis emerged
Basis = deviation from CIP; reflects USD funding premium
Persistent basis in JPY, EUR reflects structural USD demand
Uncovered Interest Rate Parity (UIP):
Expected change in spot = interest rate differential
E[delta_S] = r_domestic - r_foreign
Implication: high-yielding currencies should depreciate
Reality: UIP consistently fails — "forward premium puzzle"
Carry trade exploits this: borrow low-rate, invest high-rate
Carry works until it doesn't: violent unwind during risk-off (JPY carry unwinds)
Carry Trade Mechanics:
Return = yield differential - spot depreciation
Sharpe ratio of carry: historically 0.5-0.8 (attractive)
Risk: left-tail events (carry crashes 3-5x faster than it builds)
Risk management: size carry trades to survive 3-sigma moves
JPY carry unwind (Aug 2024): JPY appreciated 12% in 3 weeks
Current Account:
Capital Account / Financial Account:
Flow-Based FX Framework:
Currency strengthens when:
1. Current account surplus is large and growing
2. Positive rate differentials attract capital inflows
3. FDI inflows are strong (structural demand)
4. Central bank is accumulating reserves (intervention)
Currency weakens when:
1. Current account deficit is widening
2. Rate differential narrows or reverses
3. Capital flight (portfolio outflows)
4. Central bank depleting reserves to defend currency
Monetary Approach:
S = (m_d - m_f) - phi*(y_d - y_f) + lambda*(r_d - r_f)
Where:
m = money supply, y = real income, r = interest rate
d = domestic, f = foreign
Predicts depreciation when:
- Money supply grows faster than foreign (expansionary policy)
- Real income grows slower than foreign
- Interest rates rise (due to expected inflation, not real tightening)
Real Interest Rate Differential:
Most practically useful model for medium-term FX:
Real rate = Nominal rate - Inflation expectations
Currency appreciation when:
- Real rate differential widens in country's favor
- Both nominal rates and inflation expectations matter
- Central bank credibility affects inflation expectations
Example: If US real rate = 2.5% and EU real rate = 0.5%
- 200bp real rate advantage favors USD
- But if rates are converging, direction matters more than level
Types:
Effectiveness Framework:
Intervention is more effective when:
1. Consistent with monetary policy direction
2. Coordinated across multiple central banks (Plaza Accord)
3. Reserves are ample relative to daily FX turnover
4. Market is not already extremely positioned in the direction CB wants
Intervention fails when:
1. Fighting fundamental forces (unsustainable peg)
2. Reserves are depleted (triggers speculative attack)
3. One-sided without coordination
4. Market size overwhelms CB resources ($7.5T daily FX turnover)
Hawkish vs Dovish:
Hawkish surprise (tighter than expected):
- Short rates rise, front-end of curve sells off
- Currency appreciates (higher carry, capital inflows)
- Largest impact on closely-watched data: NFP, CPI, FOMC
Dovish surprise (easier than expected):
- Short rates fall, front-end rallies
- Currency depreciates
- Impact is larger when positioning is crowded against the move
Policy Divergence Trading:
Strongest FX trends occur during policy divergence:
- 2014-2015: Fed tightening while ECB/BOJ easing -> USD rallied 25%
- 2022: Fed hiking aggressively, BOJ maintaining YCC -> USD/JPY rallied to 151
- 2023-2024: Fed pivot expectations vs BOJ tightening -> JPY recovery
Monitor: rate differential trajectory, not just current level
Combine fundamental view with:
- Spot FX position (simplest, most direct)
- FX forwards (embed rate differential, no carry cost)
- FX options (defined risk, express views on vol + direction)
- Cross-currency basis swaps (exploit funding dislocations)
Position sizing:
- Size based on stop distance and portfolio risk budget
- FX is leveraged market: 1% daily moves are common (20% annualized vol for G10)
- Max 2% portfolio risk per FX trade
- EM FX: higher vol (30-50% annualized), size accordingly
Setup:
- US Fed funds: 5.25%, Fed likely to hold for 6 months
- ECB deposit rate: 3.75%, ECB likely to cut next meeting
- EUR/USD spot: 1.0850
- 2Y rate differential: US +175bps over Germany
Trade: Short EUR/USD
- Entry: 1.0850
- Target: 1.0500 (divergence continues)
- Stop: 1.1100 (invalidates rate divergence thesis)
- Carry: earn ~175bps annualized (positive carry on short EUR)
Risk/reward: 350 pips reward / 250 pips risk = 1.4:1
Plus positive carry improves effective risk/reward over time
Scenario: Oil price rises from $70 to $100/barrel
Winners (oil exporters): CAD, NOK, RUB (if tradeable)
Losers (oil importers): JPY, INR, TRY
Trade: Long CAD/JPY
- Canada benefits from terms of trade improvement
- Japan's energy import bill increases, worsening current account
- Rate differential: Bank of Canada > BOJ
- Technical: CAD/JPY near support, positive carry
Entry: 107.00
Target: 115.00 (8 big figures)
Stop: 104.00 (3 big figures)
Risk/reward: 2.7:1 plus positive carry
Analysis: NOK is 30% undervalued vs USD on PPP basis
Cheapest in 30 years on REER (real effective exchange rate)
Fundamental backdrop:
- Norway: current account surplus (oil revenues)
- Norges Bank: rates near US levels
- Oil price elevated (supports NOK)
Challenge: PPP mean reversion is slow (multi-year)
Approach: use NOK undervaluation as part of diversified carry basket
Allocate 15% of FX portfolio to long NOK/USD
Hedge with NOK put options for tail risk protection
Expected holding period: 1-3 years
Before implementing FX fundamental trades, verify: