Introduction: Probabilities, expectations, and chatter.
If I am assessing the probability of the exchange rate of a currency pair exceeding a certain price at a certain time, that expectation is going to be based, in part, on what government action may or may not occur. For all the anti-intervention chatter we hear from asset managers all over mainstream and social media, going through the following back-of-the napkin exercise has brought me to a contrarian view. Maybe some of these asset managers would like to see some kind of government action that creates profits for them.
Exercise:
Say a trader wants to borrow USD 1 million and invest it in Chinese securities that pay nine percent per year. The current exchange rate is USD/CNY=7.2855.
The trader is betting that China’s economy will improve in part due to State intervention in the foreign exchange markets and/or due to US policy to weaken the dollar. Both events, she believes, will make the dollar attractive.
She goes to the bank with a portfolio of capital made up of bonds, title to land, and title to commodities. She earns a weighted rate of return on the collateral of seven percent. Given the portfolio’s total value of USD 1 million, she earns rents of $70,000.
The bank decides to lend the trader USD 1 million at seven percent. The trader then exchanges the USD 1 million for CNY 7.285 million and invests the CNY 7.285 million into Chinese securities or assets paying nine percent.
The trader expects that the Chinese State via the Peoples Bank of China will take interventionist measures to strengthen the yuan. Due to China’s interventionist measures, the exchange rate is now USD/CNY=6.5000. Meanwhile, the trader happens to earn her expected seven percent return on her investment in Chinese securities and bags CNY 7.94065 million.
She converts the CNY 7.94065 million at the new foreign exchange rate of USD/CNY=6.5000. Dividing CNY 7.94065 million by USD/CNY=6.5000 results in USD 1.2216 million.
The trader pays back the bank USD 1 million plus seven percent interest for a total of USD 1.070 million. The bank earns USD 70,000 on the bet while the trader bags the remaining USD 151,000.
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Can the State help the bet?
In my example, what is the trader really betting on? She is betting on the expectation of State action. Take for example China. An insightful article from FXCM.com describes China’s attempts to become a central world economic player while establishing the yuan as another global reserve currency.
China has embarked on a number of policy tactics to position itself as a premier global economy. These steps have included regulating its currency’s daily price movements by fixing the exchange rate to setting ranges within which the currency rate may move. Recently, according to the article, China has allowed the midpoint of its currency price range to be influenced by the previous day’s closing value.
Your broker should be a source of information on state action.
In my opinion, private market actions are a derivative of state actions on currency and the first look should be for government action to trade on. You are trading a fiat currency, and the state actors are tilling the soil.
There is a myriad of sources of information about state action and your broker should provide you with insights and information on these actions. For example, trading platforms provide traders not just with a diverse set of trading assets such as cryptocurrencies, foreign exchange, stocks, or indices, but with the educational resources that can better help inform a trade.
Conclusion
Depending on where the trader wants a price to move, she may be on hands and knees asking for a state action. Hopefully she is not doing that. Hopefully she is staying open minded and focused on what is actually happening in the moment after studying what the policy actors are doing versus relying on wishful thinking.
Alton Drew
12 September 2023
Disclaimer: The data and output from this blog post does not constitute investment or legal advice and is not a personal recommendation from Alton Drew. Nothing contained herein constitutes the solicitation of the purchase or sale of any futures or options. Any investment activities undertaken will be at the sole risk of the reader. Alton Drew expressly disclaims all liability for the use or interpretation (whether by visitor or by others) of information contained herein. Decisions based on this information are the sole responsibility of the reader. Any visitor to this page agrees to hold Alton Drew harmless against any claims for damages arising from any decisions that the visitor makes based on such information.
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Lawyers Write the Bets. Bankers Sell the Bets. 