Global Macro Investment For Presentation at Yale U. October 22, 2003 Dr. Joe Zhou

Why do you want to become a macro money manager? Liquidity (FX market >> Bond >> Stocks)  Low transaction costs; Liquidity  if you get it right and do it in size, you become billionaire; You work for yourself  Personal Freedom; Real-time profit or loss  Instant Gratification; FX market functions around the clock  Ideal job for workaholic; Few people can do macroeconomic investing  Feel better about oneself;

Foreign Exchange Markets History 1: Floating exchange rates (1973 – present) among major currencies only 30 years old. The wealth of nations changes as currencies are constantly realigned. See charts. History 2: Governments have always been using exchange rates as macroeconomic policy tools. Current US administration clearly wants a weaker dollar as yet another tool to stimulate the economy. Presumably, a weaker dollar makes US goods and services cheaper and creates jobs. Bad News for FX Traders: Central banks have evolved smarter. They have learned to conduct better monetary policies. They have become reluctant to intervene in the FX markets. Bad monetary policies and frequent currency interventions are the kind of stuff that makes FX traders rich.

Good News 1: Nobody on this planet understands the FX markets completely. Though, everybody claims to know how to forecast the past. Good News 2: There is no shortage in sight of central banks that still face a steep learning curve. Good News 3: Home investment bias is the tendency for investors to hold assets of their own country. Home employment bias reflects the difficulty of having equal employment opportunities globally. FX investment opportunities arise so long as these biases continue to exist. Good News 4: Even if central banks stop sending money to us, there are always chances to take advantage of your fellow FX traders. Good News 5: You don’t have to be very smart. George Soros made a billion dollars by betting against Bank of England on a relatively simple trade.

Trading Instrument 1: Spot Exchange Rates. Price quote conventions; Unlike the equity trade, a spot FX trade is a bilateral contract between you and a bank; Trading Instrument 2: Forward contracts; How to establish a forward transaction? A forward position is a pair of long/short money deposits; Trading Instrument 3: Futures contracts; Marking to the market daily; Trading Instrument 4: Options; How to evaluate options? You can bet on FX directions as well as volatilities;

Market View Formation Technical Models Use historical FX price and volume data to forecast future exchange rates; Are talking about conditional probabilities and informational economics; Certain charts look prettier than others; Which are of Mean-Reverting Nature –Support and Resistance; Mean-Reverting to the trend- lines; Which are of Momentum Nature –Channel Breakout; Moving Averages; Mean-Reversion versus Momentum –Risk and Return profiles;

Fundamental Models Cost of Carry Principles applicable to all asset classes –FX, Bonds, Equities and Real Estate FX market has its own characteristics: –Monetary policy. Tight monetary policy is generally good for the currency; –Real economic growth. Higher economic growth is generally good for the currency;

Technical Models versus Fundamental Models At least 95% FX professionals are technical trend followers; On average, they make a little bit money; FX economists have not performed better than the stock analysts; like the stock analysts, they are entertainers for the investment community. When it comes to predicting future spot exchange rates, Wall Street fundamental forecasters do worse than the forward exchange rates; When too many people use momentum strategies, market volatilities go up and expected returns go down;

Quantitative Models, whether technical or not, Are all flawed philosophically. Models capture only a limited number of factors while the potential number of factors could be infinite. Certain factors, which were useful for predicting the past, may become irrelevant for the future. There could be structural changes in the market that requires considering new factors; Are better than gut feelings for most professionals. Out of greed and fear, most people trade emotionally and models are not emotional. Work better when few people use them. It is critical to develop your own proprietary trading strategies and keep them secret. Are essential for raising capital for your investment. The hedge fund community has become a quantitative industry. The black box approach to investing has been gaining popularity as gut-based managers sink in reputation;

Portfolio Risk Management Measurement of Portfolio Risk –Historical versus implied correlations; –Historical versus implied volatilities; Drawdown Control –Is about minimizing the fall of the portfolio value relative to its all- time highs; –Is a survival game. Managers are judged by their returns relative to the portfolio drawdowns; –“Optimal Investment Strategies for Controlling Drawdowns”, Mathematical Finance, July 1993.