Speculators Piling into FX Instruments

Currency speculation rather than hedging is fueling the latest surge in derivatives trading, a study by the BIS finds.


They have names like knock-ins, double one touches and three-vol butterflies. But foreign currency derivatives, which include futures, forwards and options, no longer count as exotic; increasingly, investors use them to hedge and speculate. With plain-vanilla futures and currency forwards, they’re growing in popularity along with the mammoth spot market for foreign exchange. Last month the Federal Reserve Bank of New York’s Foreign Exchange Committee reported that daily foreign exchange volume in North America surged by 14.2 percent between October 2010 and October 2011, to $977 billion. Although the main driver was a big increase in spot trading, the Fed said that over-the-counter options trading had climbed by 21 percent and that currency forwards, which also trade OTC, were up 11.3 percent.

Volatility surrounding the U.S. dollar and the euro accounts for much of the jump, says Howard Tai, a senior analyst at Boston-based consulting firm Aite Group. “The dollar’s reversal against foreign currencies last summer caught a lot of people off guard,” Tai observes. “When traders are caught off guard and not convinced where the market is headed, they don’t use a cash instrument but start using things like options, which gives them the opportunity but not the obligation to put on a hedging decision that can be taken off at a later time.”

Who’s buying all these derivatives? According to a study by the Basel, Switzerland–based Bank for International Settlements, the higher turnover in foreign currency markets was linked to more activity by “other financial institutions” — mostly hedge funds, pension funds and mutual funds. That suggests the increase was largely for speculative reasons rather than hedging.

Turnover from this category swelled 42 percent between April 2007 and April 2010. The BIS study also found that daily turnover of derivatives was $168 billion on exchanges, just 7 percent of the $2.5 trillion total, so the vast majority of trading was over the counter.

Yra Harris, principal at Chicago currency firm Praxis Trading Co., says he primarily uses currency futures for two reasons. Their main advantage: more-economical use of capital. The Chicago Mercantile Exchange allows far higher leverage on futures contracts than most bank foreign exchange dealers do. “The prime benefit of futures for me is the cost of my capital,” Harris says.

But exchange-traded futures also offer him greater flexibility than quotations from banks, because he can take a middle position between a bank’s bid and ask prices. Although he could request a new bid from the bank, it’s often too time-consuming in a market that changes in milliseconds.

Harris says he uses futures more than options, a choice reflected in statistics from the CME. Currency futures trades racked up a notional value of $29 trillion in 2011, according to the exchange, well above the $17 trillion total for 2007. Meanwhile, currency options trades were only $1.4 trillion, compared with $596 billion four years earlier.

Despite the lopsided statistics, more and more companies are choosing options to reduce hedging costs, because management and clearance of currency options has become much more standardized, notes Zohar Hod, a vice president of strategic sales at SuperDerivatives, a London-based derivatives pricing and analytics firm. “A corporate treasurer who formerly hedged his risk with simple products like futures can now buy an option and reduce the cost of that hedge in the same way buying an option on IBM is less expensive than buying IBM stock,” Hod says.

The spike in volatility in recent years gives banks and institutional investors more hedging possibilities, especially with exotic currency pairs like emerging-markets currencies, he adds. One sign that this market is expanding: Hod says his firm’s foreign exchange option-pricing business, which helps institutional investors determine the right price for a certain volatility scenario, has grown 30 percent annually for the past five years.

Most buyers of options tend to use them to hedge risk, Hod reckons. But Christopher Geczy, an adjunct professor of finance at the University of Pennsylvania’s Wharton School, says a growing number of executives at U.S. corporations who have gained expertise in hedging are now using it to speculate in currencies, according to surveys he’s conducted.

This trend worries Geczy because most companies don’t break out trading gains and losses on their balance sheets. Senior executives such as corporate treasurers can earn bigger paychecks if they profit from foreign exchange transactions, so they’ve got an incentive to take speculative positions, he explains.

“These executives reported having an edge, and I am pretty skeptical about that,” Geczy says. “It’s very difficult to imagine that corporate executives can predict currency movement. If they could, they should set up a hedge fund.” • •