The following guest post is courtesy of Neil Browning, Head of FX Sales at Saxo Bank.
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Neil Browning, Saxo Bank
Volatility is on the rise in the foreign exchange market and remains a classic trader’s conundrum. It’s well documented that when combined with liquidity, volatility creates opportunities across FX, but in periods of excess volatility, for example following China’s move to transform its exchange rate regime, there is a need to manage risk through the use of sophisticated tools or by using hedging instruments such as options.
Investors navigating the rough financial seas this year, including wild swings in financial conditions and risk appetite, the risk of a further devaluation of the Chinese currency, unpredictable reactions to central bank meetings, and concerns that the US recovery is faltering, will reach for FX options as a tool for hedging risks and leveraging market views
In terms of investor tools and pricing there has never been a better time to trade FX – largely because trader’s requirements have evolved significantly. For example, multi-asset brokers can offer an across the piece view of highly correlated market opportunities (i.e. equities driving FX and so forth). Furthermore, mobile optimisation in FX trading has also evolved – with traders now able to dip in and out of positions while monitoring total exposure. In addition, we have launched tools for traders to assess current and historic spread levels. Similarly, charting packages have become commonplace across the industry.
New tools have therefore ushered in an era of investor transparency previously unseen in the marketplace, built on a bedrock of client protection and longevity. Furthermore, pricing amongst brokers has never been more competitive, with spreads lower than we have seen for some time. At Saxo Bank, we have recently updated our pricing to increase flexibility and transparency in line with client demands and industry trends.
So, will volatility continue into the remainder of 2016? We believe it will as at this stage it appears that central banks have lost their ability to sway the market. Anticipated shifts from the Bank of Japan and European Central Bank this year however could yet spark a sharp reaction if the market decides that policy ‘means something after all’ when markets aren’t fraught as they were at times in January and February.
The risk of a potential Brexit remains foremost in sterling traders’ minds ahead of the June referendum; with incoming poll results likely to initiate violent swings both ways in the sterling exchange rate. We must of course consider the U.S. dollar as well; if the U.S. economy manages to avoid a recession and strengthens again, the market has now fallen so far behind on pricing in Fed rate hikes that it actually priced them out throughout the turmoil at the start of the year.
Finally, as touched upon at the outset of this article, the issue most likely to enhance volatility this year is the ongoing saga around China’s exchange rate policy. A slow depreciation of the renminbi (3-5% over the next 12 months) is priced in and certainly looks the likely scenario but if the world’s second largest economy decides to speed things up with a significant devaluation to assuage pressures linked to the unwinding of its rapidly inflating debt bubble, we’d expect volatility to jolt to new multi-year highs.
With volatility of this nature anticipated, effective risk management is integral.