Are the algo-trading systems ready to manage with currency volatility?

With growth of the algorithmic trading, people are beginning to comprehend how the practicalities will play out. Currency markets are often considered an enemy of quantitative investors with multi-assets as they are extremely complex and can often move in unexpected ways. The biggest problem is that historical connections can easily break and correlation analysis and give a wrong messages.

There are countless ways robotic models to approach such situations, although most often focus on long-term correlations between assets and optimization based on these relationships. In currency markets there are significant opportunities for error, which we will try to uncover.

Brexit caused problems in algo-trading. There are two key markets that help us to explain this - the UK and European markets. Robo-model would consider currency exposure in these markets. Taking the U.K. as an example first, we can isolate the relationship between U.K. equities and the GBP/USD. A robo-model is trying to quantify this relationship, typically into a single figure that helps explain the future relationship and guides positioning.

It is clear that the relationship between sterling and equity markets has changed over time, making it extremely difficult to ‘quantify’. In the 2002 to 2011 period for example, there was a moderately positive relationship between sterling and U.K. equities, which becomes particularly obvious in a five-year correlation chart. However, as time has progressed, the relationship has turned negative and shows no signs of stopping.

If U.K. equities crash, would a robo-model expect a positive or negative relationship to sterling? The answer inevitable depends on the assumption used when building the model.

Regarding the European markets, for euro-denominated investors, there is a similar issue at play. While the relationship between the euro and US dollar has been very stable in the past 24 months, an investor needs to consider what might happen to the euro if equities crash.

The historical relationship from 2004-2013 saw a similar relationship to that of the U.K. and had a moderately stable and positive correlation between the euro and European equities; i.e. the euro tended to rise during periods of market optimism. Yet, this relationship deteriorated during the euro crisis before reverting once again.

The inflationary environment and what we consider the ‘multiple deflators’ for a currency. This works on the concept of the Big Mac index - we use the more technical ‘purchasing price parity’ model or ‘PPP’, where the cost of goods in various countries provide insight into the long-term direction of currency movement. On this basis, we have seen some subtle shifts in our conviction and while we remain cognisant of the risks, we continue to see upside for the euro and sterling relative to the US dollar.

Source: MorningStar