The New World Of Emerging Market Currencies

By Richard Lee AAA

In the shadow of more industrialized economies, interest in emerging market assets has increased in recent years. Although these assets tend to be somewhat volatile, the return is often worth the risk, as emerging market funds have produced higher percentages of wealth than benchmark rates. (For the latest news and information on emerging markets, check out Emerging Market News at Forbes.com.)

Compared to the more domestic S&P 500 benchmark, emerging market fund returns have been higher and varied widely, from as little as 20% to as much as 189%, as managers dove into assets in Hong Kong, Singapore and South Africa. Interest in these emerging economies also spurred demand for the regions' corresponding currencies: the Hong Kong dollar, Singapore dollar and South African rand. This presents opportunities not only for the hedge fund trader and larger institutional speculator, but also for retail investors, who are also privy to these assets as brokers open up their platforms to include such profitable, yet relatively unknown, currency pairs.

An opportunist's dream, the emerging market currencies offer plenty of potential for the novice as well as the more tenured trader. These emerging market pairs act very similarly to their G7 counterparts, providing plenty of potential for profitability. Read on to travel through the world of emerging market currencies. (For related reading, see What Is An Emerging Market Economy?)

Emerging Characteristics
Emerging market currencies don't trade much differently than the more recognized G7 currency pairs. Although these currencies do have some drastic differences, the overview is very similar to the fluctuations in the more common European euro, British pound and Japanese yen trades. Like other major economies, these emerging market economies are dictated by monetary policy as well as political considerations, including both external and internal factors. As a result, retail and novice forex traders can actually carry over the experience they have obtained in the major industrial currencies and apply it to emerging market currency pairs.

Monetary Policy
Monetary policy can be similar between emerging countries, as their economies are continually driven and adjusted by central bank decisions. For example, similarities in policy can be seen in South Africa and Mexico. In fact, the only noticeable nuance between the two is the institution of a trade weighted system. This simply means that the currency is stabilized against a basket of currencies that is issued by the biggest trade partners of the country. The creation of the basket helps to isolate the usually free floating or managed floating currency from wild speculative fluctuations that can wreak havoc on a country's currency and its economy. In South Africa, the Reserve Bank of South Africa very loosely institutes this rule, allowing the South African rand to float freely versus other major currencies like the euro and U.S. dollar.

In order to protect the wild fluctuations in the market, a trade-weighted basket is instituted to back the currency. Recently, the central bank has loosened the policy considerably as interest rates have become a more focused concern for the markets. However, with considerations in consumer and producer prices, along with overall industrial production, the South African central bank tends to rule in favor of rate hikes or cuts, much like U.S. Federal Reserve Chairman Ben Bernanke, in adjusting the benchmark interest rate. The same is applied in Mexico, where the governor makes adjustments in the corto (central bank rate) at monthly meetings. (For more insight, see Formulating Monetary Policy.)

Central Bank Monetary Policy Head Current Interest Rate
South African Reserve Bank Governor Tito Mboweni 8.50%
Hong Kong Monetary Authority Chairman Henry Tang Ying Yen 6.75%
Monetary Authority of Singapore Chairman Goh Chok Tong 3.00
Banco de Mexico Governor Guillermo Ortiz 7.00%
Source: Bloomberg.com and the central banks of the countries listed. Information current as of November 2006.

Comparatively, central bank policy is quite different in the Singapore and Hong Kong economies. With a similar peg to the dollar as in the Chinese yuan, there is little need for central bank consideration in Hong Kong. Since the establishment of the Hong Kong Monetary Authority (HKMA) in 1993, the main focus of the central bank has been to stabilize the underlying HKD along with the banking sector, rather than maintain the stability and growth of the economy. In this way, the HKMA maintains a linked exchange rate system where the domestic currency is linked to an anchor currency, usually the British pound or the U.S. dollar.

In addition, the corresponding value of the exchange rate is backed by the equivalent value in circulation with U.S. dollars in order to maintain the stability of the underlying currency. The system is somewhat similar in the Singapore economy, as the SGD is floated by a managed, rather than trade weighted, basket of currencies. Including the economy's biggest trade partners and competitors, the contents of the basket are widely undisclosed in order to maintain the integrity of the basket and exclude it from monetary pressures and speculative fluctuations. However, broader guesses include an overweight in euros and U.S. dollars while also including the Chinese renminbi, Malaysian ringgit and Japanese yen.

On the monetary front, the Monetary Authority of Singapore issues a biannual monetary bias regarding its review of the economy in April and October. This bias helps to dictate intermediate direction in monetary policy while measuring the width of the band that restricts the overall movements of the underlying currency. Ultimately, the institution of such regimes in both economies has helped to keep the Asian currency pairs in relatively narrow ranges with intraday fluctuations keeping within a tight 30-50 point range, similar to the major Japanese yen ranges. (To read more, see Get To Know The Major Central Banks and Using Currency Correlations To Your Advantage.)

Ranges and Volatility
Another consideration is the range and volatility of emerging market currency pairs. Once again, similar to major industrial denominations, there are certain times of the day where market conditions promote a more liquid and active market. The boost in volume is similar to the major currencies where, for example, British pound trading tends to pick up in volume at the beginning of London market hours and tends to lay low around the Asian market hours. Similarly, South African rand trading picks up during the London start as well, lending to ranges as wide as 2,000 points per day, but it slows to a crawl when approaching the U.S. market midday session. Comparatively, the Hong Kong dollar tends to remain relatively low on all sessions as the currency is seemingly unaffected by mass speculation. The low-key market interest keeps the currency under constant barriers, helping to restrict the range of movement to relatively smaller 25-30 pip fluctuations. Knowing these simple nuances will help in identifying profitable currencies and their opportunities to suit each individual trader.

Currency Pair Average Daily Range Most Active Trading Time
South African Rand 871 pips 2am (EST) - 12pm (EST)
Hong Kong Dollar 25 pips --
Singapore Dollar 53 pips 3am (EST) - 12pm (EST)
6pm (EST) - 12am (EST)
Mexican Peso 546 pips 7am (EST) - 3pm (EST)
Source: Bloomberg.com

How to Trade: An Emerging Example
Let's take a look at a textbook trade, applying our technical analysis that would normally be placed on a major currency pair trade. In our example, we are going to initiate a position in the South African rand. Usually a more volatile pair, it acts much like the British pound / Swiss franc currency cross - this simply means higher ranges and wider stops.(For related reading, check out Making Sense Of The Euro/Swiss Franc Relationship.)

FX-Emerging1.gif
Source: FX Trek Intellicharts
Figure 1: A wild ride: the rand offers a lot of potential
  • Taking a look at the uptrend: At the beginning of the year, we see the U.S. dollar gain as traders in the market see the previous appreciation in the South African rand as slightly overextended, and find major support at the 6.0000 handle. Rising a whopping 15,000 points over the course of six months, dollar demand topped out as longer term resistance mad capped gains near the 7.5715 figure.With sentiment of dollar buying still somewhat positive during this period of Federal Reserve rate stabilization, traders looking to make a longer term profit are likely to pare back gains and re-initiate bids on a pullback.
  • Applying technical levels: In Figure 2, the chartist applies the everyday stochastic oscillator and Fibonacci retracements to isolate an entry on the longer term daily time frame. As a result, an opportunity presents itself as the emerging market pair consolidates perfectly on the 50% Fibonacci of the May 2006 - July 2006 advance at 6.7457. Confirmation of an uptrend is obtained through the forming golden cross in the stochastic oscillator. (To learn more, read Advanced Fibonacci Applications and Retracement Or Reversal: Know The Difference.)
    Central Bank Monetary Policy Head Current Interest Rate
    South African Reserve Bank Governor Tito Mboweni 8.50%
    Hong Kong Monetary Authority Chairman Henry Tang Ying Yen 6.75%
    Monetary Authority of Singapore Chairman Goh Chok Tong 3.00
    Banco de Mexico Governor Guillermo Ortiz 7.00%


  • Taking a closer look: Looking closer into the price action, the trader will also note the channel that has formed with additional support emerging from the lower trendline. With the golden cross almost completed, the entry here would be a bounce off of the Fibonacci level. In this case, the trader would do well to place the entry above the high of the first candle showing a reversal in the downtrend at Point A (Figures 3 and 4).
FX-Emerging2.gif
Source: FX Trek Intellicharts
Figure 2: Applying technical indicators: the chartist isolates an entry

Placing the entry: This would place the entry 10 points above at 6.8285, ensuring that when our stop entry is executed, momentum is still there to move the position higher. A corresponding stop would be applied to below the low, as it corresponds with some wiggle room for the long position below the Fibonacci level. In this instance, this would be 15 points below at 6.7035. Granted, this is a stop positioned more than 100 points away, but remember that the currency has been known to move almost 2,400 points in one session, which justifies the wider stop (Figure 4 below).

Ultimately, the long position pays off before finding considerable resistance at the even 8.000 handle as the Reserve Bank of South Africa elects to raise interest rates again, giving the rand some strength to build on. Nonetheless, this gives our trade almost 12,000 points of profit, more than a 100:1 risk/reward ratio before the longer term trend reserves, taking the currency pair lower.

FX-Emerging3.1.gif
Source: FX Trek Intellicharts
Figure 3: Taking a closer look

Conclusion
Although relatively unknown and different, emerging market currency pairs offer extended opportunities to both the novice FX traders and seasoned veterans. With market conditions similar to more accepted major currency pairs, traders are able to carry over their knowledge and experience in G7 denominations to isolate trading opportunities in the emerging market realm. However, much like how crosses compare to major currency pairs, these underlying denominations do offer differing personalities and will take time to understand. Despite this, the efforts are worthwhile, allowing investors to broaden their growth horizons and enter an opportunistic world only previously accessible to the larger institutional trader.

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