Thursday, October 9, 2008

Rethinking the short sentiment on USD...

Leveraging refers to the simple act of borrowing X USD on the basis of the collateral of Y USD, such that X >> Y. So, X/Y = m refers to the leverage ratio at play. This ratio is assumed to be "stable" over the life time of a trade. However, as the net value of Y as measured in the market reduces, the leverage factor m increases. It is clear over the past year or so, banks have been actively involved in an effort to deleverage. The consequences are unclear in the long run - however, there seems to be emerging consensus that the aftereffects of this are likely to be significant. The effects of this reduction in leverage in the FX market is particularly interesting and complex. The order of complexity is furthered by the squeeze in the credit market. While the sentiment on the US economy is remarkably short -- the question regarding the USD is more complex.

One, particular confluence of credit and FX markets is the freeze up in the lending markets. In a fine essay by Thomas Stolper and others - they hint at the mechanics and the consequences of this relationship. Most banks have short dated FX obligations and longer dated domestic currency obligations. As the overseas short term lending markets freeze -- we get banks scrambling to find assets to pay out their obligations. Since most central bank lending mechanisms only lend in their domestic currencies -- most banks are forced to borrow domestically, convert that into the foreign currency and payout. The dollar denominated debts are the highest in the world, followed by Euro denominated and so on. So, as the US lending market freezes - one should the rising demand in the USD (as counterintuitive as it might seem).

However, this is one piece of the puzzle. The trader is only concerned with the net flow of dollars and changes in value - however, it is important to keep in mind the market imperfection (frozen credit markets) work its way through structural constrains.