The currency market has never been the same since the ERM crisis of 1992. Witness the tremendous fall of the dollar against the yen and its subsequent recovery. Then add massive leveraged bets by hedge funds, the advent of barrier options, and exponential increases in the flow of both information and capital-all of which have made life difficult for corporates and propriety traders alike. Here are two bronco riders, one corporate and one trader, who have managed to keep their bearings in this volatile environment.

Trading the Treacherous New FX Markets

Andrew Smith uses options to execute trades in a difficult environment.

By Barclay Leib

As a group, FX traders have a haphazard focus on risk management and their use of options is often sporadic and undisciplined. Not so Andrew Smith, a trader with a penchant for FX options and a keen interest in risk management-two qualities that have helped him keep his bearings in rapidly changing FX markets.

Smith spent several years as an FX fund manager at Republic Asset Management, with the rank of vice chairman and chief investment officer, before moving with a small group of FX traders to Granite Capital in 1994. Last year Granite (which is unrelated to David Askin's Granite Partners) decided to farm out more of its money management to outside managers. As part of that decision, Smith took his FX crew and $100 million in funds from Granite clients and moved again, this time to Eastbridge Asset Management.

It was a surprising move to some insiders. Eastbridge, after all, is known primarily as an aggressive fixed income dealer. But the firm believed trading currencies as an asset class will become an increasingly important trading arena, and therefore wanted Smith and his gang on board to gain exposure to a market generally uncorrelated with the firm's other activities.

Like many hedge funds, Smith and his team start with a traditional macroeconomic approach, looking for fundamentally out-of-balance situations in the global economy. Smith, however, takes a more tactical approach than most in his market analysis and in the execution and timing of his trades. While many hedge funds prefer to make bets based mostly on fundamentals, Eastbridge keeps a constant eye on price action. It pays special attention to Elliott Wave analysis and other technical disciplines, and has developed its own random walk model to analyze price behavior. The goal of this analysis is to help Smith and his traders pick out genuinely trending markets from ones that are simply randomly distributed.

Options Always

What sets Smith and his crew apart in the FX world, however, is the way they use options to express most of their views. If their Elliott Wave counts and random walk model flash a trending market, and the trend fits their fundamental macro view, Smith will typically buy options aggressively. If their models turn muddled, he'll be just as quick to cash in those options or to avoid certain markets completely.

The discipline forces him to stay faithful to his trading program in difficult markets. "Most people's performances are made in two or three great months, and the trick is not to dribble it away," says Smith. He adds that options also fit well with this tactical approach to timing because they allow him to define his risk up front and to control a much larger spot position than he would otherwise be willing to carry.

One option strategy involves taking advantage of the positive "gamma" of a long option position. (See box on page 27.) For example, he might buy $50 million of a U.S. dollar call/Deutsche mark put that moves approximately 20­25 pips in value for every 100 pip movement in the underlying spot market. (In trader-speak, these options have a 0.20 or 0.25 delta.) Smith would then sell $10 million, 20 percent of the face amount of this option, at the same time. If the dollar were to move marginally lower, Smith would take back all or some of his delta hedge at a profit. Smith feels that because the gamma of 0.20­0.25 delta options is so great, it does not take much of a movement in spot to eventually finance all or most of his option via spot delta hedging. At some point Smith will typically unwind his entire hedge and let his option position run.

But if the nature of the markets changes suddenly-due to breaking news or other events-Smith may also use options as a stop-loss against increasing his underlying spot hedge. In August 1995, for example, the Japanese government announced plans to change key economic regulations. Smith believed these changes would ultimately lead to a reversal in capital flows and presaged a weakening of the yen against the U.S. dollar.

"At the time we had been structurally bearish the dollar and were incorrectly positioned long dollar puts struck at 86.00," he recalls. "I heard the announcement of the changes in the evening on CNN. Tokyo in its usual way did not react, and the U.S. dollar drifted indifferently. I bought a truckload of dollars knowing I had my dollar puts as a stop. And although my dollar puts ended up worthless, by trading against them we did very well. This is an example of where an option position can make you money even if your original directional view is the wrong way."

Smith also uses options to replace spot positions when he wishes to maintain his exposure to a macro idea, but perhaps reduce the volatility of a previously established spot position. In December 1994, with the deutsche mark just beginning an ascent that would last for much of 1995's first quarter, Smith believed that it was going to strengthen significantly against the Spanish peseta. He initially established a 25 million mark long spot position on this cross.

By February 1995 spot had reached 86.50 and Smith was up over $1 million. He still held a fundamental view that the cross was going even higher, but the temptation to book out a nice profit was also quite strong. Smith ended up selling out his cash position and replacing it with a three-month call struck at 92.00. "This allowed us to take our money off the table but to keep our macro exposure," he explains. "Implied volatility on DEM/ESP at the time seemed reasonable at 9 percent." Smith ended up selling that option in March 1995 when spot touched 93.50 and volatility was trading 22 percent. His total profit on the entire series of trades, from December to March, was approximately $3.1 million.

Voracious Time Decay

The biggest enemy of any option buyer is time decay. Smith's random walk model and other tools may help him avoid most non-trending market situations. He still runs the possibility, however, of having the right idea but being too early, or being long a strike too far out-of-the-money to become particularly useful in the fixed amount of time until that option's expiration.

Here Smith relies on a pure money management stop-loss approach. "If we buy a one-month option and we hold it for more than a week without any satisfaction, something is wrong," he says. "On a two- or three-month option, the time period we might allow ourselves would be two or three weeks. But we have to give ourselves an arbitrary cut-off point. If an anticipated price action hasn't appeared by that point-we're out. That avoids the 'time-decayed-to-death' situation. We don't let ourselves get that far."

Watching Positions

Most hedge fund managers tend to look at options in terms of how much of a cash position it allows them to control. As a result they're not particularly aware or concerned with how the value of their option positions are affected by time decay or shifts in market volatility.

Smith, however, has set up his systems much more along the lines of a sophisticated interbank option dealer. In earlier years he hired two full-time researchers from O'Connor Associates to build a state-of-the-art risk management software system, and still has one quantitatively oriented member of his team tweaking it. Smith's system, which is Unix-based and runs off a real-time feed, has six core option pricing models and five models to help his team price exotic options. The system looks at his entire position-both cash and options-in terms of his total exposure to movements in the underlying spot, to forwards, to time decay and to the implied volatility curve.

As an added feature, the system can take all of his various positions, whether they be USD/DEM, or DEM/ITL, or DEM/JPY, and by running a regression of the recent correlations between them, can convert the entire portfolio into one USD/DEM equivalent exposure, or one USD/JPY position, or whatever he deems is the key currency. Smith feels that this prepares him to react swiftly and in appropriate size should news break and the market start to move quickly.

"Our systems are designed to cope with any disaster scenario," he boasts. "When the dollar started plunging in the first quarter of 1995, and we were involved in a whole host of European crosses, we could measure the beta of each of these vis a vis the deutsche mark/U.S. dollar movement and end up with a very good approximation of our true overall exposure. This was just invaluable at the time."

Being a option player means knowing where and how to shop for your product efficiently. Smith believes the most important differences in pricing result from the underlying biases of individual banks. "Some banks are traditionally good buyers of out-of-the-money options, and others are usually better sellers," says Smith. "As you go more out-of-the-money in terms of .25 deltas and less, the biases get bigger-huge. When you are trying to get something done in the market, knowing these biases is very important."

For example, while the FX option market is indeed very mature and generally quite efficient, one bank may assign a higher "volatility smile" (see box) to out-of-the-money options than another bank. Smith may purchase an option from one bank based on its particular bias, but when it comes time to sell back his position, he makes sure that he calls other banks that historically tend to be better option buyers.

The combination of trading techniques and risk management skills made Smith a trader to watch in the late 1980s. His returns were 40 percent in both 1989 and 1990, followed by returns in the 15­20 percent range for 1991­1993. 1994 was a struggle for almost all fund managers, but Smith still posted a 3.8 percent return after costs. Since he joined Eastbridge in mid-July his group is up over 15 percent. He has accomplished this record while running his portfolio with just 7­8 percent volatility, or approximately half that of the S&P 500.

Why Performance Fell

But the critical question remains: given all of Smith's sophisticated software and overall market savvy, why have his returns trailed somewhat lower in the last two years? The drop in relative performance, he says, is partly market driven. As Smith is quick to point out, there are very few fund managers who have made money in FX year in and year out without big swings in their returns.

"Increasingly since 1992 we have had defined trading ranges, but with rather random impulse moves," he explains. "Market volatility has been less constant than it was in the 1980s, and price movement more of a 'jump-diffusion' process with one-off price changes, followed by new protracted trading ranges." In general this would appear to have made trend following and volatility trading more difficult at the margin.

As an example, one of Smith's competitors in the FX world cites the price behavior of USD/DEM in 1995. Volatility was greater than 40 percent on ten days of the year, but volatility during the rest of the year was generally less than 14 percent. This sudden and erratic price behavior may not adversely affect interbank day traders, but it does hurt the ability of hedge funds to capitalize on definitive trends. Just when it would appear that a trend has begun, market momentum wanes and prices slip into another fakeout breakout.

Some fund managers such as George Soros have blamed exotic options as a major cause of this start-stop price behavior. The theory is that when certain key levels are touched, exotic options with "knockout" features precipitate the execution of large stop-loss orders.

The reason? When a knockout option's knockout level is approached, the delta hedge on such a position may move from 60 percent to zero very quickly. Dealers, who have in effect pre-sold a stop-loss order via an option's knockout feature, need to scramble to adjust their own delta hedge position. This may result in a momentary imbalance in the market, and swift price movement, although not necessarily any ongoing volatility once the hedging adjustment is completed.

Smith agrees that there may be an element of this in today's markets, but he is generally more forgiving. "Greenspan was right," he says. "Derivatives simply distribute risk in a different manner than before, and exotic options provide another distribution mechanism. The problem is not the existence of exotic options themselves, but that people are trading them in quite considerable size-$200 million, $500 million, $1 billion at a clip-and positions of that size load up certain price levels with a lot more stress. When those levels are touched, it can become a cascading effect."

For this reason Smith likes to stay abreast of exotic options activity, just to anticipate when prices might have a tendency to accelerate. He does not actively trade exotic options, however. In general Smith believes that he can replicate an exotic option position or do another less static position and deal on a tighter bid-offered spread. For example, it may only cost Smith a $2,000 spread to get in and out of a short $10 million strangle position (short a call above the market and short a put below the market). The equivalent trade using exotic options, which could involve the purchase of a "range box" via two in-the-money double-knockout options, often has a $20,000 transaction cost both to establish it and to unwind it.

Smith believes that the real problem with currency trading in recent years has been information overload that encourages people to constantly second-guess the market. "People are constantly trying to come up with 'what-if' scenarios which people did not do in the 1980s," he says. "One does not trade on the obvious, but one trades on the piece of information which one thinks that the market does not have quite yet."

As a result Smith feels that traders often miss the most salient pieces of information. In early 1995, for example, many players were focusing on three indicators: the divergence of the Japanese yen from its purchasing power parity, the precarious state of Japanese bank balance sheets, and the decline of the Nikkei index.

Escaping Unscathed

''People concluded that the yen was going to depreciate in a similar fashion as it had back in 1990," he says. "What people missed amidst the plethora of poor economic figures on Japan, however, was the Japanese current account surplus. They also missed anticipating the strategic reserve adjustment of Far Eastern central banks that did not have enough yen reserves to offset their yen liabilities. The oversupply of dollars was tremendous...and it would not be until August 1995 that these capital flows began reversing themselves." In early 1995 the dollar declined further than most of the market anticipated, but Smith-a macro dollar bull at heart-was still able to escape the period relatively unscathed.

In the future Smith wants to expand his horizons. In particular he wants to spend more time examining the interrelationship between the pricing of FX options and the shape of the yield curves on the fixed income side. "Since so many FX desks simply take the forwards as a given, I think there is an opportunity there." He admits that transaction costs may be high for such a strategy, but one can hear the sounds of the hard disk on Smith's UNIX already spinning.

English Translation: Option Trading Terminology

By Barclay Leib

Delta: The amount by which an option's price will change for a corresponding change in the price of an underlying asset. Delta is also frequently referred to as the "hedge ratio."

Gamma: How quickly the delta will respond to changes in the price of the underlying asset. In general, the shorter the life of your option, the more sensitive it will be to movements in the underlying asset, and the faster the delta of the option will change. Gamma provides a measure of the frequency that a portfolio manager may need to readjust the delta hedge for a portfolio of option positions.

Implied Volatility: The volatility of an underlying asset's price as implied by the current market price for an option, solved for via a mathematical model. Volatility, both implied and historical, is typically expressed in annualized terms. For example, if the implied volatility for DEM/ESP is quoted at 9 percent, that means that the market expects this cross rate will be within ± 9 percent of its current, one-year forward price to a 68 percent (or one standard deviation) degree of certainty.

In the instance cited, Smith clearly thought the daily movement in this cross was going to be greater than .47 DEM pips per day, and thus elected to own an option position instead of a cash position.

Volatility Smile: In the original Black-Scholes option pricing model certain simplifying assumptions were made including that prices are normally distributed and that market volatility is constant. In the real world, of course, prices more closely resemble a lognormal distribution (prices can only go to zero, but may have a long "tail" up toward infinity) and volatility is constantly changing. Because of this, option dealers naturally assign a greater value to out-of-the-money options, which when solved backwards through the pricing model, yields a higher implied volatility for these options. The volatility smile refers to how great a premium above and beyond the at-the-money puts and calls. There may be occasions when this volatility premium is not symmetric with respect to spot due to supply and demand considerations in the market. In such instances, one might hear reference to "volatility skew."

Guarding GE's FX Downside

David Rusate seeds FX smarts far and wide in the General Electric behemoth.

By Susan Arterian

Business historians will tell you that General Electric, with a little help from Peter Drucker, virtually invented the decentralized management structure in the 1950s. Since then the organization has gone though many changes, centralizing skills and competencies that not even the largest of GE's divisions could afford independently. Like FX, for instance, where David Rusate, 39, heads a lean four-man team that acts as internal FX consultants to General Electric's industrial businesses. As Rusate describes it, his principal role is to ensure that day by day every part of GE minimizes its FX risk. "We aren't looking for a home run/strikeout scenario," he says. "We want to eliminate the downside and, if we get lucky, allow the businesses to hit a few singles and doubles."

GE sources and prices goods and services in no fewer than 30 currencies, generating in excess of $15 billion annually in non-dollar costs and revenues. Accordingly it is treasury's goal to protect operating margins and seek a limited upside through Rusate's centralized portfolio hedging program. GE's FX treasury operation is measured against standard internal and external benchmarks. But what is not so easily quantified, Rusate believes, is the real measure of his team's success: the extent to which his team is able to help business managers translate GE's superior FX execution capabilities into the best customer pricing and supplier terms.

For the industrial side of GE's businesses, Rusate's group focuses exclusively on managing transaction exposures-firm commitments, repatriated dividends and royalties, and contingent exposures arising from contracts for which GE has bid. True to the company's faith in decentralization, the business units are ultimately responsible for all hedging decisions. In practice, however, business managers look to the FX team for guidance. Only very rarely do managers decline to follow their lead or to take their suggestions on when and how to hedge. "On those occasions when we have a difference of opinion, we try to be flexible if it is at the margin," says Rusate. However, if major disagreements on hedging arise and Rusate believes that GE should employ a different hedging strategy, he can call for a meeting with the business unit's manager of finance to resolve the dispute.

Centralized Wallop

Vast economic benefits arise from a centralized hedging operation. One, it leverages GE's purchasing power with banks. Two, it allows for monitoring of counterparty risk. Three, it permits superior internal controls. Once the hedging decisions have been made, corporate treasury nets the exposures of GE's 12 businesses and executes the hedges. GE uses the Citibank subsidiary CROSSMAR's FX Match, a real-time electronic confirmation system, for all forward and spot contracts. (CROSSMAR promises to deliver a real-time confirmation on options contracts later this year.) Internally GE uses FX Press, a reporting system developed by an outside vendor, that links contracts to exposures and produces mark-to-market and other reports for senior management.

Rusate's team employs a portfolio approach to avoid any extreme hedging outcomes. The portfolio consists of three techniques: forwards, stop-loss/take-profit orders layered around technical support and resistance levels, and options (usually currency puts, since GE is almost always in a net long currency position). "The art of the deal," says Rusate, "is selecting a suitable mix of those instruments." If the outlook for a given currency is neutral, the mix is likely to be 50 percent forwards, 25 percent options and 25 percent stop-loss/take-profit orders. For most of 1994­1995, when, GE saw the potential for the yen to strengthen significantly, related exposures tended to be covered 30 percent with forwards and the remainder with a combination of options and stop-loss/take-profit orders. "That is probably the most aggressive we have ever been in providing upside to the portfolio," says Rusate.

His current market view is that the dollar is in a short-term uptrend that is likely to extend through the middle of the second quarter, but that the long-term trend continues to be down. "Early this year we gravitated toward a more defensive hedging strategy-75 percent forwards and 25 percent options," says Rusate.

Born in Connecticut, Rusate's career in corporate risk management began with Union Carbide 14 years ago, where he worked in FX treasury positions in Singapore and Hong Kong. He then moved on to Pepsi for three years, where he experienced the hyperinflationary markets of Latin America. He joined GE three years ago as assistant treasurer. Working out of GE's campus-style corporate headquarters in Fairfield, Connecticut, the treasury FX staff consists of Rusate and Chris Johnson, a currency analyst. In addition Ying Siew San and Rob Farrow manage FX in Singapore and London, respectively.

Perhaps the most challenging part of FX treasury's job, and where Rusate asserts his group can add the most value, is in educating the businesses to better understand their exposures. Top-level management training is one way that the message gets spread. Junior business managers attend a financial management program in Crotonville, New York, where they are given a course in currency risk management for nonfinancial professionals. Rusate and his team also take their message on the road, conducting workshops for purchasing and marketing personnel at local business operations around the globe.

To keep in touch with their internal market, Rusate's team conducts a weekly FX market intelligence conference call that includes the pension trust as well as all the industrial businesses. Both U.S. and local non-GE market specialists alert managers to upcoming events that may impact currencies, like elections, or monetary or fiscal trends.

Workshop Insights

U.S. business managers are not spared Rusate's proselytizing. While they may initially believe that if they sell in U.S. dollars to foreign customers they have no exposure to foreign currencies, they learn the contrary after attending one of the FX treasury workshops. Treasury managers quiz them about what happens to their businesses when the dollar appreciates. Managers will invariably answer that export orders tend to decline as potential customers buy from a supplier that is willing to assume the currency risk. Conversely the customer that has agreed to make payment in dollars is apt to come back to GE for price relief because the invoice has skyrocketed in local currency terms. "We try to explain to the business managers that neither one of those outcomes is optimal," says Rusate, "and it is many times better for us to take on the currency risks ourselves and manage them up front." FX treasury then works with businesses to price appropriately in the local currency so that there is a known return to the business and no risk to the customer.

For example, if the GE turbine business in Schenectady is exporting to Japan, they are encouraged to bill in yen and understand the attendant opportunities and risks. "We explain that there are benefits in billing in premium currencies where interest rates are lower than the U.S. dollar," says Rusate. Today, in the case of the yen, the unit can achieve a 4.25 percent annual benefit by hedging its yen receivable. The unit can take this currency differential to its bottom line, or it may need to pass on a price reduction to achieve the order, especially if it is competing with a Japanese supplier.

If, however, a business is billing in a discount currency, such as Italian lire, it is instructed that there is a cost to hedge the related receivable. The business needs either to build that cost into its price or to find some other way to reduce costs if it wants to remain competitive with local suppliers.

On the purchasing side, Rusate's team encourages business units to source internationally and ask for two quotes-one in U.S. dollars and one in the currency of the supplier. "We can easily make those two currency quotes apples and apples for them, and it really helps in the cost analysis process." Thanks to GE's triple-A credit rating-and the market clout it exercises thanks to the sheer volume of its FX transactions-GE can invariably hedge the local currency quote back into dollars at a rate that beats the supplier's dollar quote.

Eschewing Complexity

Rusate steers clear of complex options; even range forwards tend to be too risky for GE's purposes. "Our board of directors wants absolutely no speculative downside risk to our strategies," he says, "and thus we have not asked for nor do we need or want authority to enter into complex, risky instruments. The FX team, with support from corporate accounting, requires that the businesses must have a firm commitment with no risk of cancellation before any hedging strategy is executed."

FX treasury measures the success of each and every hedge against the closing spot rate, the inception forward rate and the plan rate. The plan rate, set by corporate treasury, is devised by calculating the average forward rate. The most important goal for the upcoming year is achieving the plan rate, says Rusate, while the other two benchmarks offer a measure of how well the portfolio strategy has performed versus an unhedged or a 100 percent hedged strategy.

FX treasury has formulated strict risk control policies and practices. Separation of execution and back-office function is strictly enforced. Support staff who monitor corporate treasury's FX trades report separately to the manager of finance for each of the various businesses.

The company trades with fewer than 15 banks in FX so that counterparty risk can be closely monitored, best pricing obtained, and meaningful volume placed with the banks. GE uses triple-A rated banks for deals of five years or longer, double-A banks for one-year to five-year deals, and single-A or better for deals of one to 364 days. The term of GE's hedges can be as short as one month, in the case of the short-cycle lighting business, or as long as five to seven years, for the longer-cycle businesses like power systems and transportation locomotives.

Another of GE's criteria is that the banks use the FX Match system, which confirms trades electronically on a real-time basis. "We think that is critical in the event that there is a miscommunication between the bank and one of our traders," says Rusate. "We don't have to wait until the end of the day for a phone call or two days later for a paper confirmation to find out we have a major discrepancy on our hands."

Of course, good pricing is always a paramount consideration. Banks must also be perceived market leaders in all major currencies, options and emerging markets.

Daily market advisory services are not much value, however. "We have Reuters and all the same information that would cross the bank sales desks ourselves," notes Rusate. "We don't need them to call us with the news that the Fed has just cut interest rates, but we do appreciate their perspective, insight and first-rate technical analysis." By the same token, since GE shies away from risky, complex derivatives, bank product specialists are not likely to get much of a hearing in Fairfield.

Rusate would like to see more competition and consistency in banks' options pricing. "I don't think the banks have, across the board, invested as much as they should in that area," he says. Amongst its FX bank group-including U.S. money center banks, European and Asian banks, and investment banks-fewer than half are truly strong in options, in Rusate's view, though he declines to be more specific.

Avoid Oncoming Trains

When it comes to serving GE Investment Corporation (GEIC), FX treasury's approach tends to be more opportunistic. The non-dollar exposures arising from foreign equity investments are significant and tend to be long-term. "When it comes to equity exposures, we look more at trying to get them out of the way of an oncoming train-say, a major devaluation," says Rusate. Sometimes that may not require an actual hedge, because if there is a fair amount of political risk in the country anyway, the portfolio manager may simply choose to sell the stock and eliminate the exposure altogether.

Because GEIC's $1 billion foreign bond portfolio has a shorter duration than the equity portfolio, the impact of currency moves on the bond portfolio can be significant. Rusate's group tends to manage these exposures more actively, using the same portfolio hedge strategy as on the industrial side of the business.