Apr 17, 2015

Currency Wars: Quantitative Easing, Negative Rates & FX Trading Impact

From Europe to Asia it seems not a day goes by without news of another major central bank easing monetary policy, or taking rates to zero, or below. In fact, last week marked the 14th central bank to ease monetary policy so far this year.

As the “Currency Wars” debate heats up, in this blog Numerix FX expert Udi Sela, focuses in on Denmark and the recent pressure they’ve been under – specifically the likelihood of having the Danish National Bank follow the footsteps of the Swiss National Bank and abandon its peg to the Euro. Udi examines the outlook for the Danish Krone and how the negative rate environment across the is impacting FX options trading strategies.

 Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section.

Video Transcript:

Jim: Hi, welcome to Numerix video blog, your expert sources of derivative trends and topics.  I’m your host, Jim Jockle.  From Europe to Asia, it seems not a day goes by without news of another major central bank easing monetary policy or taking rates to zero.  In fact last week marked the 14th central bank to ease monetary policy so far this year.

Taking a look at this graphic, specifically in the EU you can see main policy rates in zero or negative territory represented in red.  Including, Denmark, Norway, Sweden, Finland, Germany, France, Spain, Ireland, the UK, Italy, and Greece.

As the currency war debate heats up, today I’d like to focus on Denmark, and the recent pressure they’ve been under. Specifically the likelihood of having the Danish National Bank follow the footsteps of the Swiss National Bank and abandon its pegging to the Euro.  Joining me today to discuss this is Udi Sela, VP of the Numerix Client Solutions Group and resident FX expert.  Udi, how are you today?

Udi: Thank you, very well Jim.  Thank you for having me.

Jim: And thank you for joining us.  So why don’t we just start and perhaps you can provide us the latest on the situation.

Udi: Right, so everyone is probably aware of the surprising decision by the Swiss National Bank stopping the pegging of the Swiss franc to the euro at 1.20.  They have been buying hundreds of billions of euros against Swiss franc for 3 years since 2011. And on the 15th of January they have decided they would change the policy and will not support the Swiss franc anymore. When I say support basically weaken the Swiss franc.  Because Switzerland is foreseen as a safe haven investors have traditionally placed funds there.  And during the rough times, since the European Central bank has envisaged quantitative easing the Swiss national bank has determined that it would be too costly for them to protect the Swiss franc or if you’d like to weaken the Swiss franc.

As a result, that one day the Swiss franc has strengthened by almost 40% against the Euro. Which of course has created shock waves across the industry.  It was the biggest volatility ever experienced in the FX market since 1971, in one day.  So basically investors now are looking for similar pegged European currencies and looking for a similar play.

And the country they chose was Denmark. Because Danish krone is pegged to the euro in the tight range of 2.25% which is actually enforced in the ranges of less than one percent so basically what investors were doing was buying Danish krone, and hoping that the Central Bank would not be able weaken the Danish krone.  And indeed we were seeing the Central Bank buying billions of euros against the Krone for months, and even the Central Bank is announced that it’s stopping its financing program, and not issuing bonds until 2016.  They cut the rate, the discount rate to -0.75 %.  Pretty much aligning it with the interest rate in Switzerland.

So, you mentioned negative rates, we actually saw negative rates of the 10 year government bonds in Switzerland trading at -30 basis points.  And the Danish 10 years government bonds trading at zero.  A similar affect we’ve also seen the corporate bonds issued at negative rates.  So basically investors pay money to pay interest to corporates for parking the money with them, which is unheard of.  That’s pretty much the backbone of it Jim.

Jim: Thank you Udi.  And we’ve seen some market participants come out saying that the unpegging to the euro is going to be very unlikely as this time.  Just this week Fitch has come out to confirm Denmark’s rating at AAA with a stable outlook.  But they did note that however monetary easing to defend the peg may not come without risks.  Namely the risk of negative valuation and sharp currency appreciation and buildup of credit risk in the financial system.  So just turning towards option trading, what are some of the strategies that individuals in the FX market should be thinking about given this negative rate environment?

Udi: So that actually there are 2 questions embedded in one question. Firstly, how can one profit or even hedge against sudden unpegging of the currency?  For instance, we read that Citibank  lost 150 million dollars from the unpegging of the Swiss franc, and what was interesting to know that they had options hedging the downside which expired a week before the Swiss National Bank’s decision.  That’s kind of shocking.

In this sense we, at Numerix also proposed a play a few years ago in the case of a euro breakup buying barrier options betting on the strengthening of the Danish krone (as a result of a Euro breakup) .  So you can do this by buying put options:  buy a   put Euro call on Danish krone, or even just by buying one touch options (targeting the downside of this currency pair). So if the range of 2.25% is broken then set the strike price at something like 7 Danish Krone to euro, you could buy a one touch option which either hedges or investments betting on the Euro breakup.

Now if you look at the negative rates, one of the things that we saw during the subprime crisis then come back again is people betting on CMS spread, the 2 Years/10 Years spread is currently very narrow. So one of the bets is that it can’t get narrower. Another bet is that given that some bonds trade at negative yields (e.g. Swiss 2 years at -0.90%), sell a floor struck at rate (say -1% for 2Y Swiss government bond).  And there is a market for that now.  These are options that are very difficult to price, but people will make you price them.  So that will be an interesting thing.

Jim: Well Udi thank you so much for shedding light on this topic. And of course we look forward to discussing this again with you soon.   On the Numerix video blog our goal is to examine the risk management, derivatives and regulatory topics that you want to talk about.  Keep the conversation going on LinkedIn and on Twitter @nxanalytics.  For up-to-date industry news, blogs, videos research and technical papers, follow us on LinkedIn or visit us on numerix.com.  Thanks for joining.

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