Mean currency reversion is the tendency of a currency’s foreign exchange price to revert back to a natural level over time, based on its forward and spot interest rates, and the relative inflation rates of the nations being examined. The end result is that an investor can take a look at the fundamentals of currency exchange rate to determine if there is a discrepancy, and asses the risks associated with this discrepancy. Most importantly, by understanding how it is that a currency’s price today compares to its fundamental value, we can look to see if a currency bubble exists, and therefore threatens our personal portfolios.
The first step to determining a currency’s fair value is to evaluate its fair price against its main trading partners as a function of its inflation rate and interest rate. This is accomplished by evaluating something called ‘interest rate parity’. Specifically, we want to see that the currency price reflects the opportunity costs of putting funds into a savings account in another denomination, after taking inflation into account.
Since an investor should theoretically be able to earn the same amount of money by holding funds in a savings account for either currency pairing, we should see that the currency prices balance out as a function of their exchange rate, plus the difference in interest rates between the two countries’ savings accounts.
From there, we will immediately see that there is a discrepancy between the prices listed by banks, and the calculated amount that we’ve just found. This difference represents the currency’s ‘risk premium’. The trick for an investor is to then look back over time to see how large that premium has traditionally been, and use an average to determine that consistent level that the country will usually return to over time.
This average risk premium amount is known as the mean reverting level, and will present us with an indication of how far apart the real exchange rates between two countries will often remain. By understanding this relationship between currencies as a function of interest rate differentials and risk premiums, we can then take a step further to interpret how it is that the relationship between real prices and expected prices can indicate a pricing bubble.
To evaluate the exchange rate of a currency against its mean reverting level, we need to look for indications of excess that demonstrate risk. This is accomplished by evaluating the change in the country’s risk premium over time. If we see that the difference between two countries’ risk premiums are decreasing, we need to understand why this is, because it might indicate that a correction is about to take place. We can accomplish this by evaluating the sources of change that impact a country’s currency premium. Specifically, we want to see that a risk premium has been decreasing as a result of a federal government improving its financial positioning.
This includes the establishment of additional funds in an FX reserve fund to support the integrity of demand for the riskier currency, a decreasing inflation rate, reduced volatility in equity markets (to show stable investment demand for currencies), and the maintenance of a stable terms of trade, suggesting that the export/import markets of the country are stable. Alternatively, seeing the degradation of these aspects of an economy can suggest that a risk premium should actually be increasing, and that the currencies are mis-priced.
The end result is a risk that a correction could actually create a self-perpetuating currency crisis that will send the economy further into a recession based on its inherent stability. Such has been the case multiple times in the past for countries in Asia and Latin America, and will likely continue to be examples of currency risks into the future.