Alternatives for executing Foreign Exchange for Institutional Investors.

JULY, 2009

By Francisco J. Heredia | Boston Global Associates

This piece is intended as a primer for institutional investors new to the foreign exchange market. This market is very complex and its participants and their needs substantially differ from one another.

For most institutional investors (other than the ones with dedicated staff) the execution of their foreign exchange (FX) is an afterthought. Unless, you have been trading global securities for some time and you are comfortable with the magnitude of the market’s volatility.

When there is the need to purchase or sell currencies for the purpose of hedging or funding a primary trade, foreign exchange becomes a derivative, a secondary trade. A derivative that’s not as important to their primary investing objectives. There are investors that do not have a dedicated team to follow the currency market and are willing to give up the trades to their custodian, equity or fixed income salesperson to execute on their behalf. The assumption is that they do not have the man power to closely monitor this particular market and therefore it’s cheaper to give it to their primary coverage salesperson to execute via their FX desk. Some go even further by contracting their custodian bank to execute on their behalf via their internal FX desks.

Many years ago, when institutional investors invested mainly in domestic securities there was no need to worry about the FX market, even later on when diversification meant just to invest in a handful of countries. But nowadays, when almost every investor is looking for global diversification there is an inherent need to go abroad and to participate in many more countries. Additionally, the globalization of the financial markets has meant a greater correlation between nations and currencies; therefore you might need more of them for your diversification. And nowadays, FX is perceived by many to be an alpha generating asset class.

Other than calling your local bank/broker what are the alternatives and what else do you need to consider? Well, first and foremost you need to be aware of trading risk, and what I mean is the execution of FX by people unaware of the intricacies of this market (in other words, the execution by non-FX traders). A way to mitigate some of the risk is by utilizing electronic trading platforms to help you monitor your execution. The benefit is that it’s not necessary to have a dedicated person to execute your FX; the volume will dictate when you need to hire someone. In the mean time, any of the traders executing international equity or global fixed income can be paired with a web based platform to execute your FX. How do you know you are getting the best rate (price discovery)? Well, let’s remember that the foreign exchange market is the largest market in the world ($3.2 trillions a day), it st.....




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