The global currency markets need no introduction - they will be known to investors as highly liquid (at over $3,000 billion turnover per day), low-cost and with efficient execution.

The conventional wisdom is that, in international investment, taking currency risk along with underlying equity or other market risk is generally unrewarded - and therefore that hedging some or all of that currency risk is an efficient use of the investor’s risk budget. This consensus is well supported by the evidence - namely that taking random currency exposure (determined by your international asset allocation) is a zero-sum return which adds to risk.

We all also know that the core function of the currency market is to facilitate trade and cross-border transactions of every type.  The development of the currency markets around the world have mirrored this need, with international banks leading the development of the marketplace and the instruments that customers can use for trading and hedging.  Even today, we estimate that the vast majority of trading in the currency market (90%+) comes from customers who are not pure currency investors - rather they are companies and individuals for whom currency transactions are an essential concomitant to another activity or trade (exporting; importing; cross-border investment).  This makes currency the ideal market for the pure currency investor - a large pool of liquidity which is not chasing pure currency returns.

Currency Risk Premium

However, there is another function of the currency market which has been sitting under the noses of the investment community for nearly 40 years, and which they have, in my opinion, not fully recognised.  This is the financing by the private sector of now very large imbalances in current account balances of the major currency blocs.

Let’s take an example. The US has been running large current account (i.e. external) deficits for many years now.  Aside from the recent Chinese policy of buying US Treasuries for their reserves, over the years the private sector has been willing to finance these deficits by constantly increasing their holdings of unhedged Dollar-denominated investments.  Why have they been prepared to do this, since holding unhedged US Dollars creates investment risk in the hands of investors around the world whose currencies are not Dollars ?

They have been prepared to do so because the US Dollar has offered a return premium to compensate for the risk taken in holding it.  This is not an ‘inflation’ premium (although it is sometimes thought to be); it offers a premium even after relative inflation differentials have been stripped out.  Why and how ?  Why is easy - if it did not offer a premium, then no rational investor would hold Dollars (or increase their holding).  In just the same way, if holding equities (which are risky) did not generate a long-term return premium, then no rational investor would buy-and-hold equities.

How ? The answer is yield. Deficit countries in general, and the US Dollar in this example, have offered higher after-inflation yields than surplus countries over the past more than 30 years.

As with all things in the currency markets, there is always a mirror-image, because currency exchange rates are in pairs.  So for every deficit country by value, there is a surplus country.  Surplus countries have historically offered their citizens lower short-term interest rates (i.e. yield) than deficit countries - and this has encouraged these citizens to seek higher returns (and therefore investment risk) elsewhere.

FTSE Currency FRB5 Index

Can we quantify the risks and returns that investors have faced in their deficit-financing activities over 30+ years ?  Until six months ago, we could not.  But now FTSE, the global index provider, has created the FTSE Currency FRB5 series of indices, which track the Forward Rate Bias (FRB) since 1978.  The Forward Rate Bias is exactly what I have described above - namely the observation that higher-interest-currencies’ return have outperformed lower-interest-rate-currencies by virtue of the higher interest rates more than compensating for the currency depreciation caused by their higher inflation.  Academics have observed, with some puzzlement, the FRB for nearly twenty years.  It has been described as the ‘forward premium puzzle’ - illustrating my contention that the academic community has not fully recognised the role of real (i.e. after inflation) interest rate differentials in the financing of international trade imbalances.

The FTSE Currency FRB5 index construction is very simple - it tracks the performance of an equally-weighted portfolio of one-month rolling forward currency contracts of all 10 of the pairs that can be made up with five currencies (USD, EUR, JPY, GBP, CHF) in the index.  The only rule is that once a month the determination of which is the ‘long’ position in each pair is by reference to which currency has the higher 1-month money-market interest rate.

So even with a very simple rules-based index to identify the currencies that are attracting funding through their enhanced yield, this index produces an information ratio (return/risk) of 0.5 (=2.9% / 5.8%) over 32 years to Dec 2010.  This is much higher than the information ratio available from equities over this period. 

The FTSE Currency FRB5 series gives a similar overall return to the equities series, but with only 40% of the volatility - a level of volatility more commensurate with a bond portfolio than an equity portfolio.  Most importantly, the FRB5 series is not correlated with the equities series - so it is a genuine provider of diversification over long periods of time.  This is despite relatively high positive correlation with equities in 2008, when all risky assets were priced in a similar way.


We make the argument that the currency risk premium is not a ‘market inefficiency’, but a fundamental return to reward and encourage investors from surplus countries to invest in deficit countries by accepting the risk of holding their currencies.  In this way it has strong resonances with the equity risk premium.

Fortunately the drivers of the currency risk premium (real (after inflation) yield differentials) are completely different from the drivers of the equity risk premium (earnings; P/E ratios; tax rates), so the long-term investor can be reasonably confident that return correlations are going to remain structurally low.

Neil Record is Chairman & CEO of Record Currency Management, a leading institutional currency manager