FX Value - PPP Strategy.
Purchasing power parity (PPP) is a theory concerning the long-term equilibrium exchange rates based on relative price levels of two countries. The concept is founded on the law of one price; the idea that in absence of transaction costs, identical goods will have the same price in different markets. Different countries of course consume different baskets of goods, but it is partially possible to asses relative price level (to assess which country is „cheaper“ and which is „more expensive“ for living). PPP theory then says, that price differences between countries should narrow over time by exchange rate movements or by different speeds of inflation (which also has some implications on exchange rate movements).
Fundamental reason.
As it was already mentioned - different countries consume different baskets of goods and it is partially possible to asses the relative price level. Price differences between countries narrow very slowly over time. A rebalanced portfolio which has the actual most undervalued and overvalued currencies helps to capture gains from exchange rate convergence to fair value.
value, FX anomaly, forex system.
Simple trading strategy.
Create an investment universe consisting of several currencies (10-20). Use the latest OECD Purchasing Power Parity figure to assess fair value of each currency versus USD in the month of publishing and then use monthly CPI changes and exchange rate changes to create fair PPP value for the month prior to the current month. Go long 3 currencies which are the most undervalued (lowest PPP fair value figure) and go short 3 currencies which are the most overvalued (highest PPP fair value figure). Invest cash not used as margin on overnight rates. Rebalance quarterly or monthly.
Source Paper.
Valuation - In the long run, currencies tend to move towards their „fair value“. Consequently, systematically buying „undervalued“ currencies and selling „overvalued“ currencies is profitable in the medium term. One of the strongest conclusions in academia is that fundamentals tend not to work for currencies in the short to medium term, yet they do long term. One of the oldest measures of „fair value“, purchasing power parity, has been shown to work in the long run.
Other Papers.
Kroencke, Schindler, Schrimpf: International Diversification Benefits with Foreign Exchange Investment Styles.
Style-based investments and their role for portfolio allocation have been widely studied by researchers in stock markets. By contrast, there exists considerably less knowledge about the portfolio implications of style investing in foreign exchange markets. Indeed, style-based investing in foreign exchange markets is nowadays very popular and arguably accounts for a considerable fraction in trading volumes in foreign exchange markets. This study aims at providing a better understanding of the characteristics and behavior of stylebased foreign exchange investments in a portfolio context. We provide a comprehensive treatment of the most popular foreign exchange investment styles over the period from January 1985 to December 2009. We go beyond the well known carry trade strategy and investigate further foreign exchange investment styles, namely foreign exchange momentum strategies and foreign exchange value strategies. We use traditional mean-variance spanning tests and recently proposed multivariate stochastic dominance tests to assess portfolio investment opportunities from foreign exchange investment styles. We nd statistically signi cant and economically meaningful improvements through style-based foreign exchange investments. An internationally oriented stock portfolio augmented with foreign exchange investment styles generates up to 30% higher return per unit of risk within the covered sample period. The documented diversi cation bene ts broadly prevail after accounting for transaction costs due to rebalancing of the style-based portfolios, and also hold when portfolio allocation is assessed in an out-of-sample framework.
In asset classes such as equities, the market beta is fairly clear. However, this question is more difficult to answer within FX, where there is no obvious beta. To help answer the question, we discuss generic FX styles that can be used as a proxy for the returns of a typical FX investor. We also look at the properties of a portfolio of these generic styles. This FX styles portfolio has an information ratio of 0.64 since 1976. Unlike its individual components, the FX styles portfolio returns are relatively stable with respect to underlying regimes in S&P500. Later we replicate FX fund returns using a combination of these generic FX styles. We show that a combination of FX trend and carry, can be used as a beta for the FX market. Later, we examine the relationship between bank indices and these generic FX styles. We find that there is a significant correlation in most instances, with some exceptions.
We document the existence of excess returns to naïve currency trading strategies during the emergence of the modern foreign exchange market in the 1920s and 1930s. This era of active currency speculation constitutes a natural out-of-sample test of the performance of carry, momentum and value strategies well documented in the modern era. We find that the positive carry and momentum returns in currencies over the last thirty years are also present in this earlier period. In contrast, the returns to a simple value strategy are negative. In addition, we benchmark the rules-based carry and momentum strategies against the discretionary strategy of an informed currency trader: John Maynard Keynes. The fact that the strategies outperformed a superior trader such as Keynes underscores the outsized nature of their returns. Our findings are robust to controlling for transaction costs and, similar to today, are in part explained by the limits to arbitrage experienced by contemporary currency traders.
We show that measures of currency valuation derived from real exchange rates contain significant predictive content for FX excess returns and spot exchange rate changes in the cross section of currencies. Most of the predictability stems from persistent cross-country differences in macroeconomic fundamentals. This suggests that currency value mostly captures risk premia which vary across countries but are fairly static over time. Moreover, our results do not support the standard notion that trading on simple measures of currency value is profitable because spot exchange rates are reverting back to fundamental values. When decomposing real exchange rates into underlying macroeconomic drivers, however, we find that refined valuation measures relate more closely to "currency value" in the original sense in that they predict both excess returns as well as a reversal of exchange rates.
The authors of this book examine the rationale for investing in currency. They highlight several features of currency returns that make currency an attractive asset class for institutional investors. Using style factors to model currency returns provides a natural way to decompose returns into alpha and beta components. They find that several established currency trading strategies (variants of carry, trend-following, and value strategies) produce consistent returns that can be proxied as style or risk factors and have the nature of beta returns. Then, using two datasets of returns of actual currency hedge funds, they find that some currency managers produce true alpha. Finally, they find that adding to an institutional investor’s portfolio even a small amount of currency exposure — particularly to alpha generators — can make a meaningful positive impact on the portfolio’s performance.
We examine the ability of existing and new factor models to explain the comovements of G10-currency changes. Extant currency factors include the carry, volatility, value, and momentum factors. Using a new clustering technique, we find a clear two-block structure in currency comovements with the first block containing mostly the dollar currencies, and the other the European currencies. A factor model incorporating this “clustering” factor and two additional factors, a commodity currency factor and a “world” factor based on trading volumes, fits all bilateral exchange rates well, whatever the currency perspective. In particular, it explains on average about 60% of currency variation and generates a root mean squared error relative to sample correlations of only 0.11. The model also explains a considerable fraction of the variation in emerging market currencies.
How to Choose the Best Stock Valuation Method.
When trying to figure out which valuation method to use to value a stock for the first time, most investors will quickly discover the overwhelming number of valuation techniques available to them today. There are the simple to use ones, such as the comparables method, and there are the more involved methods, such as the discounted cash flow model. Which one should you use? Unfortunately, there is no one method that is best suited for every situation. Each stock is different, and each industry sector has unique properties that may require varying valuation approaches. The good news is that this article will explain the general cases of when to use most of the valuation methods.
Two Categories of Valuation Models.
Valuation methods typically fall into two main categories: absolute and relative valuation models. Absolute valuation models attempt to find the intrinsic or "true" value of an investment based only on fundamentals. Looking at fundamentals simply mean you would only focus on such things as dividends, cash flow and growth rate for a single company, and not worry about any other companies. Valuation models that fall into this category include the dividend discount model, discounted cash flow model, residual income models and asset-based models.
In contrast to absolute valuation models, relative valuation models operate by comparing the company in question to other similar companies. These methods generally involve calculating multiples or ratios, such as the price-to-earnings multiple, and comparing them to the multiples of other comparable firms. For instance, if the P/E of the firm you are trying to value is lower than the P/E multiple of a comparable firm, that company may be said to be relatively undervalued. Generally, this type of valuation is a lot easier and quicker to do than the absolute valuation methods, which is why many investors and analysts start their analysis with this method. (For more, see The 4 Basic Elements of Stock Value.)
Let's take a look at some of the more popular valuation methods available to investors, and see when it is appropriate to use each model.
Dividend Discount Model (DDM)
The dividend discount model (DDM) is one of the most basic of the absolute valuation models. The dividend model calculates the "true" value of a firm based on the dividends the company pays its shareholders. The justification for using dividends to value a company is that dividends represent the actual cash flows going to the shareholder, thus valuing the present value of these cash flows should give you a value for how much the shares should be worth. So, the first thing you should check if you want to use this method is if the company actually pays a dividend.
Secondly, it is not enough for the company to just a pay dividend; the dividend should also be stable and predictable. The companies that pay stable and predictable dividends are typically mature blue-chip companies in mature and well-developed industries. These type of companies are often best suited for this type of valuation method. For instance, take a look at the dividends and earnings of company XYZ below and see if you think the DDM model would be appropriate for this company:
In this example, the earnings per share are consistently growing at an average rate of 5%, and the dividends are also growing at the same rate. This means the firm's dividend is consistent with its earnings trend which would make it easy to predict for future periods. In addition, you should check the payout ratio to make sure the ratio is consistent. In this case the ratio is 0.125 for all six years which is good, and makes this company an ideal candidate for the dividend model. (For more on the DDM, see Digging Into the Dividend Discount Model . )
Discounted Cash Flow Model (DCF)
What if the company doesn't pay a dividend or its dividend pattern is irregular? In this case, move on to check if the company fits the criteria to use the discounted cash flow model. Instead of looking at dividends, the DCF model uses a firm's discounted future cash flows to value the business. The big advantage of this approach is that it can be used with a wide variety of firms that don't pay dividends, and even for companies that do pay dividends, such as company XYZ in the previous example.
The DCF model has several variations, but the most commonly used form is the Two-Stage DCF model. In this variation, the free cash flows are generally forecasted for five to ten years, and then a terminal value is calculated to account for all the cash flows beyond the forecast period. So, the first requirement for using this model is for the company to have predictable free cash flows, and for the free cash flows to be positive. Based on this requirement alone, you will quickly find that many small high-growth firms and non-mature firms will be excluded due to the large capital expenditures these companies generally face.
For example, take a look at the simplified cash flows of the following firm:
In this snapshot, the firm has produced increasing positive operating cash flow, which is good. But you can see by the high level of capital expenditures that the company is still investing a lot of its cash back into the business in order to grow. This results in negative free cash flows for four of the six years, and would make it extremely difficult or impossible to predict the cash flows for the next five to ten years. So, in order to use the DCF model most effectively, the target company should generally have stable, positive and predictable free cash flows. Companies that have the ideal cash flows suited for the DCF model are typically the mature firms that are past the growth stages. (To learn more about this method, see Taking Stock of Discounted Cash Flow . )
Comparables Method.
The last method we'll look at is sort of a catch-all method that can be used if you are unable to value the company using any of the other models, or if you simply don't want to spend the time crunching the numbers. The method doesn't attempt to find an intrinsic value for the stock like the previous two valuation methods do; it simply compares the stock's price multiples to a benchmark to determine if the stock is relatively undervalued or overvalued. The rationale for this is based off of the Law of One Price, which states that two similar assets should sell for similar prices. The intuitive nature of this method is one of the reasons it is so popular.
The reason why it can be used in almost all circumstances is due to the vast number of multiples that can be used, such as the price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S), price-to-cash flow (P/CF), and many others. Of these ratios though, the P/E ratio is the most commonly used one because it focuses on the earnings of the company, which is one of the primary drivers of an investment's value.
When can you use the P/E multiple for a comparison? You can generally use it if the company is publicly traded because you need the price of the stock and you need to know the earnings of the company. Secondly, the company should be generating positive earnings because a comparison using a negative P/E multiple would be meaningless. And lastly, the earnings quality should be strong. That is, earnings should not be too volatile and the accounting practices used by management should not distort the reported earnings drastically. (Companies can manipulate their numbers, so you need to learn how to determine the accuracy of EPS. Read How To Evaluate The Quality Of EPS.)
These are just some of the main criteria investors should look at when choosing which ratio or multiples to use. If the P/E multiple cannot be used, simply look at using a different ratio such as the price-to-sales multiple.
The Bottom Line.
No one valuation method is perfect for every situation, but by knowing the characteristics of the company, you can select a valuation method that best suits the situation. In addition, investors are not limited to just using one method. Often, investors will perform several valuations to create a range of possible values or average all of the valuations into one. With stock analysis sometimes it is not a question of the right tool for the job so much as it is how many tools you have to tweak out different insights from the numbers.
How to value FX forward pricing example.
Definition.
An FX Forward contract is an agreement to buy or sell a fixed amount of foreign currency at previously agreed exchange rate (called strike) at defined date (called maturity).
FX Forward Valuation Calculator.
FX forward example.
trade date : 1/oct/2012 maturity date: 1/oct/2013.
on maturity date A will buy 100 USD at exchange rate EURUSD 1.23.
FX forward pricing.
What market data do we need?
forward points EUR discount curve.
Forward points for 1 month represent how many basis points to add to current spot to know the forward EURUSD exchange rate.
(for valuation date of today could be found on page fxstreet)
for example if forward points for EURUSD for 1 month is 30 and eurusd spot for valuation date is 1.234 then.
the forward rate EURUSD for valuation date+ 1 month would be.
FX forward valuation algorithm.
calculate forward exchange rate in euros: Forward in dollars=spot+Forwardpoints/10000 , Forward in Euros=1/ForwardInDollars caclulate net value of transaction at maturity: NetValue=Nominal*(Forward-Strike) discount it to valuation date with EUR discount curve: NPV=DiscountFactorEUR(maturity)*NetValue.
FX forward example valuation:
valuation date: 1/oct/2012.
market data:
forward FX points EURUSD 12months = 100.
discount factor EUR (1/oct/2013) = 0.9.
Spot EURUSD (1/oct/2012) = 1.234.
1) calculate FX Forward for 12 months maturity:
Forward 12m EURUSD=1.234+100/10000 = 1.244.
Forward USDEUR = 1/1.244=0.8039.
2) calculate value at maturity:
strike in EUR = 1/1.23 = 0.813.
Value(maturity)=100 (0.8039-0.813)=-0.91496 EUR.
3) descount value to valuation date.
NPV= 0.9*(-0.91496)=-0.82346 EUR.
Excel calculation example (you can edit white cells):
Forex Tutorial: Economic Theories, Models, Feeds & Data.
There is a great deal of academic theory revolving around currencies. While often not applicable directly to day-to-day trading, it is helpful to understand the overarching ideas behind the academic research.
Where 'e' represents the rate of change in the exchange rate and 'π 1 ' and 'π 2 'represent the rates of inflation for country 1 and country 2, respectively.
Interest Rate Parity.
Where 'F' represents the forward exchange rate; 'S' represents the spot exchange rate; 'i 1 ' represents the interest rate in country 1; and 'i 2 ' represents the interest rate in country 2.
Where 'e' represents the rate of change in the exchange rate and 'i 1 ' and 'i 2 'represent the rates of inflation for country 1 and country 2, respectively.
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