Intro to DEER; from FX valuation to trading
18Trading currencies is about identifying misalignments. One looks at a current exchange rate, then take a position on it based on your analysis that it is likely to strengthen or weaken. On a day-to-day basis, this can be done by looking at charts and tracking relevant news. But currencies are driven over the longer horizon by deep forces of economics and finance.
DBS Equilibrium Exchange Rate or DEER is a data-driven, rigorously tested model of currency valuation. The DEER model gives insights on long-term exchange rates. These insights are based on three key concepts. Firstly, Purchasing power parity or PPP. PPP is well-accepted as a key driver of exchange rates. If the price of a good varies across geographies, it must be the case that over time those differentials would converge through adjustments of the exchange rate. Secondly, the Balassa-Samuelson effect. It captures the stylised fact that countries with higher productivity tend to have higher real exchange rates than expected under PPP alone. Thirdly, terms of trade. It is a country’s export price to import price ratio. Higher terms of trade bolsters a country’s trade balance and incomes, and tends to lead to currency appreciation.
The DEER model calibrates weights across all these three factors to derive a currency’s fair value; the valuations are based on economic fundamentals. Zero weight is given to changes in market sentiment, risk events, or short-term market factors. Misalignments from our DEER fair values will eventually narrow, but this process is more observable over the long-term than the short-term. We estimate that DEER misalignments tend to narrow by half over a 3 to 4 year period.
Currencies that are expensive compared to their DEER fair value should underperform over time, and those currencies that are cheap relative to their DEER fair value are expected to outperform.
Returns from DEER strategy are uncorrelated with global fixed income returns, and are only mildly correlated to S&P 500 returns. The addition of the DEER strategy’s FX returns could add an important dimension to returns from a traditional equity and fixed income portfolio, and this gives investors additional diversification benefits that are rare in liquid asset markets.