David DeRosa is one of the world's most well-known foreign exchange traders. He is the author of Managing Foreign Exchange Risk, a popular introduction to foreign exchange markets and risk management techniques, and Options on Foreign Exchange, a detailed treatise on currency options, both published by Irwin/McGraw Hill.

DeRosa started his career as an academic, graduating from the University of Chicago Graduate School of Business with a Ph.D. in finance. He's held a variety of portfolio management and trading positions on Wall Street, all of which involved the use of foreign exchange derivatives. DeRosa recently left the foreign exchange trading group at SBC Warburg to start Quadrangle Investments LLC, a new Greenwich, Conn.-based hedge fund. He was recently appointed adjunct professor of finance at Yale University School of Management. DeRosa spoke with editor Joe Kolman in December.

DS: You've been a foreign exchange trader for most of your career. What do you like about it?

DD: There are a lot of reasons. It's the only true global, 24-hour market. The size is so large that you can do things in foreign exchange that you could not think of doing in other markets. I think that's why so many exotic options have appeared in foreign exchange. I also like it because it is really the crossroads of world affairs. I like news and I try to think in terms of both politics and economics. Nothing happens of any importance that does not show up in exchange rates.

DS: What has happened to volatility in foreign exchange lately? Have the central banks really defeated the hedge funds on this count?

DD: That's what the popular press would have you believe. These conspiracy theories only take you so far. This one is no more believable than the proposition that hedge funds and speculators can cause volatility. No one controls the market for foreign exchange any more than anyone controls the weather. It is well known that this market is subject to clustering of volatility. Isn't this the essence of the statistical findings that the returns distribution is "leptokurtotic," or, in other words, with fat tails? You are either in the horse latitudes or at the Cape of Good Hope. For the past two years volatility has been quiet and that is all you can say. The right confluence of world economics and political affairs will make it roar once again.

DS: What is your read on the future of the foreign exchange business? Some people are getting depressed these days.

DD: Well, volume is down, profits are down, there are layoffs and dealing room closings. We even have competition from robots, the electronic dealing services. Who wouldn't be depressed? I think foreign exchange is going through a difficult period, which is only natural after so many years of rapid growth. Maybe it was just FX's turn to go through the Wall Street boom-bust cycle. The market now also has to adjust to new technology, like the electronic dealing systems.

DS: So what's going to happen?

DD: The business probably will shrink for a time, regroup, restructure and then begin to grow again. Everything that is essential always comes back. But some of the familiar faces may not be there in four or five years.

DS: What does that mean?

DD: I think that the future of the foreign exchange dealing business will be with size, technology, and with those who understand how to deal and manage the risk of related derivative instruments.

DS: You have been described as a Euro-skeptic. What does that mean?

DD: I am skeptical because I fear that the European politicians have entrapped themselves in a monetary agreement that is neither economically feasible nor politically sustainable. The lack of economic feasibility will become apparent when and if there is a single European Central Bank that faces its first mild recession. One can easily see Southern Europe demanding an easy monetary policy in the face of resistance from Central Europe (particularly Germany). It doesn't even have to be a recession. It could be a general dissatisfaction with differential rates of economic growth. Local pressure would mount for fiscal stimulus. Here then is the question: Is it realistic to believe that the EC would have the political will to impose huge fines on deficit violations in this scenario? Doesn't the Stability Pact have to give?

Moreover, the road to one currency may include some sort of ERM policy for the second-tier currencies -something that I doubt would be realistic.

DS: Why not?

DD: The ERM as it existed before August 1993, before the 15 percent bands were put in place, was a disaster. There were more than 50 devaluation's from 1979 to 1993, plus two spectacular currency crises. Its predecessor, known as the "Snake," which was around during and after the Smithsonian period in the early 1970's, was also a failure. What chance will they have in fixing Euro-Spain or Euro-Greece in 1999 when they couldn't peg Deutsche mark-French in 1993?

I have always been doubtful as to the value of fixing exchange rates. So many exchange rate regimes have failed. Moreover, the damage caused by the chaos of the system breaking down may far outweigh whatever short-run benefits might have come from the period of interim stability. I am not ashamed to admit that my University of Chicago colors maybe flying on that point.

DS: Do you think Europe is really ready to unify its currencies?

DD: Look at one simple fact: The vast majority of German citizens are opposed to giving up the mark. Note that the politicians have not bothered to ask the voters-there will be no referendum because it is not required and because the voters would have almost certainly said no. I predict that this will be a point of permanent resentment. Later on, I cannot imagine that the rest of Europe is going to be too thrilled once it sees the new European Central Bank in action.

DS: But is there something inherently wrong with Europe going to a single currency?

DD: In the micro sense, not really. It just means that the member countries will have one single monetary policy. In the macro sense it bothers me. I see EMU as part of a longtime struggle to bring parts of Europe together as one super trading block. I know that this is justified against the backdrop of two horrific world wars and everyone's desire to ensure that this never happens again. But where I get concerned is that the unification process has brought a creeping measure of federalism, the agricultural policy being a prime example. I fear that the advent of a single currency will make it far easier for regulation of industry and broad economic activity. In that sense, it may be dangerous to Europe's long-run health.

DS: Can you see any good whatsoever in the EMU?

DD: There is one thing. The whole debate on the stability pact has focused the attention of the politicians and, to a lesser extent, the electorate, to the financial reality of their social systems-and it is not a pretty picture.

DS: You have been outspoken on the U.S./Japanese trade war and you've said it had disastrous consequences.

DD: I feel that the United States is partly to blame for Japan's slow recovery from its recession. The Clinton trade warriors tried to do what even General MacArthur could not do. The General tried to dissolve all traces of the Zaibatsu holding groups. Later they were back and became stronger than ever. The lesson is that you can't institute structural change in Japanese business from the outside. Mickey Kantor tried to change the way Japan does business and he failed too, in my estimation. Worse yet, these efforts have focused attention in Japan away from the real problem of how to get out of the recession. This can be seen in the fact that the new Prime Minister Hashimoto is in fact the former trade negotiator, Mr. Kantor's old counterpart.

DS: All of this started with the Japanese bubble economy

DD: Right, the crash of the market in real estate and stocks. The bubble was created by a surplus of liquidity in Japan that drove up asset prices. You began to see ridiculous things, like million-dollar golf club memberships (for non-playing members!). Remember the "tokeen" funds? This is where a company would borrow off of the strength of its balance sheet and plunge the money in the stock market.

I can remember speaking to Japanese financial institutions in 1989 about investing in the United States and Europe. The attitude was that Japanese markets lead the rest of the world markets up and that there would be no benefit to international diversification because if Japan crashed, so would the other markets. Finally, BOJ governor Mieno decided to do something about the "irrational exuberance," to use a recently popular phrase. He raised interest rates. I guess he was expecting merely to slow things down a bit. What he perhaps didn't appreciate was that Japan was truly an over-leveraged speculative bubble. The crash obliterated the stock market as well as real estate, the other part of the bubble.

DS: How does a country recover from that?

DD: It goes bankrupt-that is, if it can go bankrupt. In some places it cannot go bankrupt. A prime example is Kuwait. The Kuwaiti stock market was also a huge speculative bubble. There was a very interesting "when-issued" market called the "Suq-al-Manak." This was the market for new off-shore Kuwaiti companies formed in Bahrain and in the UAE. The day this market crashed, 90 billion dollars in stock market-related checks bounced. The problem in Kuwait is that no one could go bankrupt-the courts took away the assets but the debts remained. The result is an economy that is left to wallow in an unresolveable network of interconnected financial claims. Recessions that are caused by stock market bubbles are very hard to get over if there is no bankruptcy process to clear away the rubble. I think Japan has had the same problem. The problem may be not so much that a few Japanese companies are going broke but rather that more cannot or do not want to go bankrupt.

DS: Your outlook?

DD: Maintaining low interest rates will not be enough if I am right

that there is still a good amount of legal and structural impediments to clearing the decks. But I think Japan is capable of fixing itself. My worry is that U.S. trade policy has been and may continue to be a harmful distraction. I am interested in Japan as a good long-term investment. The near term is less certain in my mind.

DS: What do you make of what's become a heated debate about value at riskin this magazine and elsewhere?

DD: This is going to be a hot topic for some time to come. The backdrop to this debate is the tremendous success of the derivatives revolution. On the heels of this, some well-known financial catastrophes occurred. Naturally, the industry, especially the banks, had to come up with some metric for understanding this new complex risk. The most obvious approach was to apply concepts from portfolio theory in an attempt to quantify capital at risk from the standpoint of probabilistic loss limits.

DS: What's wrong with that?

DD: Two things, at least. First, the approach is reliant on the accuracy of the correlation (or variance-covariance matrix)-and here the devil is in the "tails" of the distribution. Second, I am not convinced that there is or can be adequate treatment of the risk of movements in implied volatility in the case of options positions. In fact, one of the largest losses I ever witnessed was when hedge funds were buying huge quantities of dollar call / yen puts at levels below 90 (USD/JPY). The dealing community got crushed when the vols moved up several big figures-but spot had not changed.

DS: So you're in basic agreement with what Naseem Taleb said in our December Q&A.

DD: Naseem Taleb is the most outspoken opponent of the value-at-risk approach. If I get his argument correctly, he is saying that risk is more subtle than what can be contained in a correlation matrix. I have to agree but I don't think that that means the whole VAR approach is flawed. I think of VAR as the first meaningful attempt to quantify derivatives portfolio risk. To be fair to Taleb, I think he is saying not so much that VAR is wrong but that a naïve and superficial reliance on it to understand and manage risk is dangerous. Whatever you think of his stand-and he is a worthy opponent, for sure-you should look at his book before you bet the ranch (or the bank) on VAR. Nonetheless, there are parts of VAR that are important.

DS: Such as?

DD: It is useful to a trader in that it gives a linkage between positions, risk and capital usage. It also is

important because it explicitly recognizes that correlation among positions can imply a different risk profile than stand-alone trades would suggest.

DS: We've also seen something of a debate on the use of exotic options in FX. Where do you stand?

DD: I am in favor of using them, with some exceptions. For example, I think that barrier options (the bulk of the exotics in the market) fall into two classes. Knock options, where the out-strike is in the out-of-the money region, are quite useful. They are cheap, fixed-premium, relatively high-delta bets. But kick options are more accident prone. They have outstrikes in the in-the-money regions and are hazardous for hedgers because the hedge goes away when it is most needed.

DS: Any other exotics you like?

DD: Yes, the so-called lock or digital range options, which afford the trader the chance to go short volatility but with a fixed premium. The option has a fixed digital payoff provided that the spot level has not gone outside of the range during a period of time. I regard this as one of the most useful derivatives inventions in years.

DS: You've just started an investment management company. Do you consider yourself a hedge fund?

DD: I think you could say so in the sense that we are leveraged and measure ourselves in regard to a total return target. The approach is macro- fundamental. We don't really use technicals much at all. We operate in three main sectors-foreign exchange, interest rates and equities. For foreign exchange, we look at direction and volatility. In terms of equities, we are primarily relative-value oriented. Officially, my company is the investment manager for the Versailles Fund, a Cayman Islands fund.

DS: Several of the largest and most well-known funds have reduced size or have actually gone out of business. Why are you optimistic about the industry?

DD: We are probably thinking about the same funds. I think 1994 was a pretty horrific year for many managers. Some of them had become very wealthy and probably tired of the responsibility of managing other people's money. Most of them are still trading but with their own funds. I am optimistic about the industry because I doubt that the stock and bond markets will be able to generate double digit returns going forward. People will renew their interest in alternative asset strategies.