Even before the money set aside to pay back the US’s debts threatened to run out at the end of October, markets struggled with the way the dollar has bounced around over the past 18 months.

At the Federal Reserve, outgoing chairman Ben Bernanke’s ‘forward guidance’, which was meant to steer us gently through the exit from extraordinary monetary policy, did exactly the opposite.

In early summer, the chairman indicated that the central bank might slow its purchase of securities by the end of the year, keeping the Fed Funds rate anchored near zero, at least until unemployment came in below 6.5%. Of course, markets are discounting mechanisms, and pretty much every market worldwide re-priced as if the Fed were planning to shrink its balance sheet and raise rates the day after tomorrow. Bond yields raced up, emerging markets threw a tantrum and the dollar index bounced sharply from its post-crisis low. Tapering failed to materialise, perhaps because of this reaction, and that left everyone scratching their heads.

Our lead article filters the noise around the world’s reserve currency and its underlying theme – currency markets are a treasure trove of alpha guarded by highly-aggressive dragons of volatility – runs through the rest of this month’s report.

A contribution from ESSEC Business School looks at the spot-level forecasting information inherent in the FX option volatility smile and the fatness of the tails of the implied volatility distribution.

Another article considers how interest rate ‘normalisation’ should lead to increasing global interest-rate differentials and FX volatility, leading not only to greater alpha opportunities for active currency managers, but to the prospect that active currency might be deployed as a short-duration replacement for a proportion of an investor’s fixed-income portfolio – as long as you avoid those dragons, of course.

This subject is pursued further in our final article, which looks into the improving attitude of investment consultants to active currency management after some years of reluctance. Even so, the market remains scarred by the experience of 2008, when the carry strategy that consultants arguably focused on was particularly badly hit by the flight to the safety of the dollar and yen.

Those fears about the FX volatility dragons no doubt explain much of the reluctance to recommend active management of currency hedging overlays, too. There remains a suspicion that this adds risk by the back door, rather than reducing it. We reconsider the case for optionality in the active overlay as a risk-reducing process, and ask which instruments and strategies are best-suited to the job.