J U LY 2 0 1 2

Currencies: A Primer
W H I T E PA P E R

I NV ESTMENT MANAG E M E N T & G U IDAN C E

AHMED S. HASNAT, VP, PORTFOLIO STRATEGIES DESK

SULTAN KHAN, AVP, PORTFOLIO STRATEGIES DESK KEY IMPLICATIONS
ANIL SURI, CIO, MULTI-ASSET CLASS MODELED SOLUTIONS The foreign exchange (FX) market is the
largest and most liquid financial market
in the world, playing a critical role in the
The global economic crisis of 2008 was a humbling and painful experience functioning of the global ecoonomy.
for many. In its wake, more than ever investors are seeking non-correlated ■■Uses of foreign exchange
assets that can deliver consistent returns and help protect against downside Governments, corporations, institutions,
and individuals are all, directly or
risks. One such type of asset that is familiar to everyone, but is typically not indirectly, players in the vast FX market.
thought of as an investment, is currencies. They utilize currencies for a variety of
reasons both mundane and exotic. Four
basic uses are:

1. For transactional purposes

I
2. As a tool for hedging exchange rate
t is difficult to overstate the importance of foreign exchange for the world risk
3. As an instrument for speculation
economy. From the price of gas at the local pump to the cost of a vacation 4. As a portfolio asset
abroad, changes in the foreign exchange (FX) market affect governments, The focus of this paper is largely on
this last and most recent development
corporations, and individuals on a daily basis. Each day a staggering $4 trillion in FX thinking, which is opening up
in trades take place in currency markets around world; by comparison, U.S. stock opportunities for investors to integrate
currencies into their strategic asset
trading averages just $135 billion a day, and U.S. bonds about $1 trillion.1 allocation framework.

Ironically, the largest financial market in the world is also one of the least understood. ■■Currency as a portfolio asset
Analyzing the performance of currencies,
In this paper, we attempt to demystify this important market by examining the basics we find that adding FX exposure to
of currency investing and its impact on a traditional portfolio. a traditional portfolio of stocks and
bonds can potentially enhance returns,
reduce volatility, and increase portfolio
E VO LV I N G RO L E S O F F O R E I G N E XC H A N G E diverfication. Significantly, we find that
currencies tend to be most effective
Historically, currencies have performed two functions critical for society: serve as a unit in a portfolio during periods of market
of account and act as a medium of exchange. And since money assumed different forms in distress, when other assets are falling
in lock-step.
different places, there was always a parallel need for foreign exchange. For millennia, the
■■Gaining exposure to currencies
foreign exchange market has provided a forum for commercial activities between peoples. Investors, today, can gain exposure to
currencies through a growing variety of
Not much changed through the ages until the early 1970s, when the breakdown of the channels, direct or indirect, passive or
active. The most important ways are:
Bretton Woods system of fixed exchange rates gave birth to the modern FX market.
1. Investments in foreign stocks and
For the first time, the price of currencies would be set according to the forces of supply bonds
and demand. Exchange rate risk became an inescapable consequence of cross-border 2. Currency derivatives
3. Currency baskets and strategic
commerce and investing. Currency suddenly had two new roles: as a tool for hedging indexes
foreign exchange exposure and an instrument for speculation — the most famous 5. Structured/market-linked products
6. ETFs/ETNs
example being the $1.2 billion in profits hedge fund manager George Soros netted 7. Actively managed funds (mutual
shorting the British pound in 1992. funds, commodity trading advisors,
global macro and currency-specialist
hedge funds)
1
Bank of International Settlements (BIS), Securities Industry and Financial Markets Association (SIFMA)

This material was prepared by the Investment Management & Guidance Group (IMG) and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of IMG only and
are subject to change. This information should not be construed as investment advice. It is presented for informational purposes only and is not intended to be either a specific offer by any Merrill
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© 2012 Bank of America Corporation. All rights reserved.
There is now broad consensus among academics and
practitioners alike of yet another role for currencies: as
a form of portfolio investment. This new understanding
of foreign exchange is based on two well-documented
attributes. First, currencies exhibit low correlation to
established asset classes; and second, strong evidence that
(contrary to economic theory) certain currency strategies
can offer sustainable returns over time. The focus of
this paper will largely be on this new development in FX
thinking, which enables investors to integrate currencies
into their strategic asset allocation framework.
THE CURIOUS CASE OF CURRENCY MARKETS
The idea of currencies as a separate asset class was
initially controversial because, among other things, the FX
market is a zero-sum game. Since currencies are always
traded in pairs (e.g., USD/EUR, EUR/JPY, etc.), every long
position automatically has an offsetting short position.
That meant, unlike the equity or fixed-income markets,
the FX market as a whole should not increase/decrease in
value as gains in some currencies are offset by losses in
others. Technically speaking, the FX market had no beta.2
For a long time, the conventional view was that foreign
exchange represented uncompensated risk in a portfolio.
Exchange rates might temporarily move in one’s favor, but
over the long run the efficiencies of the market ensured
that gains and losses would “wash out.”
Yet the track record of active currency strategies shows
they are capable of garnering consistent returns over time.
If the currency markets offered no systematic returns, the
gains would have to be purely the result of managerial
skill, or alpha.3 But if the FX market was “efficient” it
should not offer such opportunities. What explains the
incongruity? For an answer we turn to poker.
Ante up: Segmenting the FX market
Consider a regular game of poker played among friends.
Whatever one player wins some other loses, with the
winnings and losses summing to zero. In any such group
there are usually some players who are more skilled than
others, and those players would be expected to win money
on average. If profits were the sole purpose of playing, the
“rational” behavior would be for the weaker players to quit.
However, many people play simply because they enjoy doing
so, even when they consistently lose. In such a scenario, the
less skilled players are effectively paying a premium for the
external benefits of playing (such as entertainment).
Likewise, participants in the FX market also have different
objectives, expertise and resources. They can be divided
into two broad groups: profit-seekers and liquidity-seekers.
The former aim to gain from currency trading, while the
latter primarily want to ensure they have access to the
FX market to conduct international transactions. Studies
confirm that profit-seekers are generally better informed
about currency prices than liquidity-seekers. And like the
less skilled poker players, liquidity-seekers are willing to
pay a currency premium to attract profit-seekers into the
FX market. That means, as a group, profit-seekers gain
from currency trading, while liquidity-seekers lose. The
latter are not overly concerned by such an outcome as they
do not necessarily view trades in terms of profit-and-loss
and are accomplishing other goals.
Hedge funds, CTAs, sovereign wealth funds, etc. are
examples of profit-seekers who devote considerable time
and resources to analyzing the “fair value” of currencies.
On the other hand, corporations that want to import
merchandise or repatriate profits from operations abroad,
investors seeking to purchase foreign securities or hedge
exchange rate risk, central banks that intervene in the FX

Figure 1: B
 rief history of currency markets
9000–6000 B.C.
The concept of money arises.
Livestock and grains earliest
forms of currency.
500 B.C.
Advent of modern coinage in
Imzir (modern-day Turkey) that
is portable and durable.
1800s-1930s
UNIT OF ACCOUNT and MEDIUM OF EXCHANGE
Paper currency (“fiat” money)
is common. To be fiscally
sound, countries back currency
with gold reserves. But during
the Great Depression, gold
standard adds to deflationary
pressure, hampering economic
recovery.
Post WWII–1970s 1980s–2000s Present
PORTFOLIO HEDGING TOOL and SPECULATIVE INSTRUMENT
PORTFOLIO INVESTMENT
Post WWII the gold-to-USD rate Speculative currency trading Wide acceptance of currency
is fixed, while all other major grows. Evidence of persistent as a stand-alone asset class,
currencies are pegged to the returns among currency traders recognition of alpha and beta
USD. In 1971 U.S. abandons attributed to manager alpha. components to returns.
ties to gold and floats currency,
ending system of fixed rates.

The concept of beta is akin to a “rising tide raising all boats.” It represents the market return.
2

Financial theory says returns on any portfolio can be decomposed into these two basic components, alpha (α) and beta (β), and an error term, epsilon (ε), which denotes random
3

events or “noise” (which may sometimes be positive, sometimes negative). Statistical analyses can help differentiate whether a portfolio’s excess return over the market (beta) is the
result of true managerial skill, α, or chance, ε.

2 WHITEPAPER
market, and foreign tourists, are examples of liquidity- If the structure of the currency markets provide systematic
seekers. Significantly, the presence of these two distinct returns to those willing to assume the risks, then one
groups means that a currency beta can, in fact, exist. question is what portion of the existing market consists of
Of course, the above description ignores an important profit-seekers? Figure 2, below, highlights the relative size
component of the FX market: dealer banks that act as of the different segments of the FX market. Notice that
intermediaries between the profit-seekers and liquidity- not only has the FX market nearly tripled in size over the
seekers. These are usually large commercial and past decade, but it has undergone significant structural
investment banks that take the other side of transactions changes as well. Today, profit-seekers, such as hedge
initiated by either party. For providing liquidity to the funds, are responsible for the majority of FX trading. Their
market, they receive a positive “bid-ask” spread.4 (Note, increased presence makes price discovery more efficient.
our poker example still holds in this tri-party framework. While that’s good news for liquidity-seekers, it also means
It is the equivalent of playing poker at a club, where the shrinking premiums for profit-seekers.
house “dealer” takes a percentage of the winnings or
charges a fixed fee per hand.) Figure 2: D
 aily turnover in the FX market by source
From theory to practice: Are profit-seekers profitable? (in $billions)
100%
The idea of a two-tier market of profit-seekers and 90% $300 $500
liquidity-seekers is intuitive, but is it an accurate 80%
$300
description of the FX market in practice? Empirical studies 70%
60% $1,900
using futures data published by the Commodity Futures
50%
Trading Commission (CFTC) indeed confirm that one 40%
group systematically profits at the expense of the another. 30% $1,000
20% $1,500
The results of one such study by the Reserve Bank of
10%
Australia are reproduced in Table 1. 0%
1998 2010
Banks Investment Funds Corporates and Central Banks
Table 1: A
 verage weekly profits by trader type 1993-2003 Source: Bank of International Settlements (BIS), 2010
(in US$ millions)*
Non-commercial/profit- Commercial hedgers/
seekers liquidity-seekers
Common FX Styles: The hunt for “beta”
Gross Profit Net Profit** Gross Profit
A feature of any asset class is that a significant portion
Australian Dollar 0.45 0.41 -0.72
of their returns can be correlated to a set of distinct
British Pound 0.05 -0.21 -0.58
Canadian dollar 0.62 0.46 -0.63
investment styles or rules. In the case of equities, for
Euro (1999-2004) 4.97 4.51 -7.71 example, research shows that consistent returns are
German mark (pre-1999) 3.63 2.93 -5.71 possible by being systematically long small-cap stocks and
Japanese yen 5.42 4.65 -8.62 short large-cap stocks, buying value stocks and shorting
Swiss franc 1.85 1.43 -3.52 growth stocks, and purchasing recent winners and
Total 12.72 10.44 -20.84 shorting recent losers (momentum). That meant returns
Source: Kearns, J. and Manners, P. (2004). The Profitability of Speculators in Currency Futures that were formerly unexplainable (and considered alpha),
Markets. Reserve Bank of Australia. *The CFTC data only report the positions of large speculators
and hedgers (holding more than 400 contracts). These large traders account for about 70% of the could be re-categorized as different forms of stock market
total value of positions in the currency futures markets considered in the study. The remaining
contracts fall into a residual category so that total profits sum to zero. beta. The implications of these findings extend beyond
**Assumes transaction costs of 0.03%.
just academic interest. For one thing, it allows managers
to better understand and control the risks in their equity
portfolios. For another, it opens the possibility for investors
to gain exposure to returns less expensively through
standardized products.

The bid-ask spread is difference between the price at which a dealer is willing to buy, and the price at which he is willing to sell a currency pair. Note, that in addition to their role as
4

market makers, dealings banks have traditionally run separate proprietary trading desks that take directional bets on currency movements using the bank’s own capital. These activities
have generally been small compared to the client business and have shrunk further in light of new legislation that limits proprietary trading by banks, such as the Volcker Rule.

WHITEPAPER 3
 Box 1: T he nuts and bolts of the FX market
Structure of the FX market
The currency “market” that we commonly refer to is
really a decentralized network of large banks around
the world operating 24 hours a day, five days a week.
The vast majority of FX trading is done over-the-
counter (OTC), where every trade is a private
transaction between the dealing bank and client,
akin to the interaction between a bank teller and a
customer standing at the counter. The closed nature
of the arrangement means that, unlike in the equity
markets, there is no certainty that the quote received
for a particular currency pair is the best available.
Traders may contact multiple dealers to establish
best price. The mechanics of currency trading are
illustrated in Chart 1, below.
A small amount of FX trading also takes place on
public exchanges, such as the Chicago Board of
Exchange (CBOE), involving standardized currency
futures and currency swaps.
Key FX trading instruments
OTC products can be tailored according to the
buyer’s needs by amount, maturity, and currency.
The trade-off is that with greater customization
comes correspondingly less liquidity and higher
transaction costs for contracts. Three types of currency
instruments commonly utilized in OTC transactions are
spot, forwards, and FX swaps (see Chart 2).
A spot transaction is the most straightforward, and
simply involves exchanging one currency for another
at the prevailing exchange rate (similar to a tourist
changing money at the local bank). Spot transactions
usually settle in one to three business days.
A forward transaction is an agreement between two
parties to exchange one currency for another at a fixed
rate at some date in the future.
An FX swap combines a spot transaction with the
benefits of a forward contract. One currency is
swapped for another (usually a spot transaction) and
swapped back (via a forward contract) to the original
currency at a future date.
The most common exchange-traded FX instruments
are futures and currency swaps. Futures are simply
standardized versions of forwards. Currency swaps are
Chart 1: I llustration of typical FX market transactions
ABC requires pounds to Network of FX dealers
import goods from U.K.
$1,500,000
ABC Co. Bank 1
₤1,000,000
₤1,000,000
$1,499,600
Fund manager believes
the pound is overvalued.
Shorts GBP.
$1,499,500
Hedge Fund
Bank 2
₤1,000,000
Source: Merril Lynch Investment and Guidance (IMG)
4 WHITEPAPER
contracts that involve the exchange of principal and
interest in one currency for another.
In addition, there is a thriving FX options market
in both the OTC inter-bank market and on futures
exchanges. Options provide investors with an efficient
way of gaining exposure to currencies. Exchange-
trade options are based on futures prices and have
standardized strike rates, contract size, and maturities;
which are all negotiable in the case of OTC options,
which use the spot currency as the underlying asset.
Most popular currencies
While there are more than 170 currencies, ten
currencies are responsible for more than 90% of the
total daily FX turnover. These include the U.S. dollar
(USD), euro (EUR), Japanese yen, British pound (GBP),
Swiss franc (CHF), Australian dollar (AUD), Canadian
dollar (CAD), Swedish krona (SEK), Norwegian krone
(NOK), and the New Zealand dollar (NZD).
The USD is by far the most popular currency. The size
of the U.S. economy, its deep financial markets, and
reputation for stability ensure its prominence in the FX
market. Over half of all international debt securities
and more than 60% of the foreign reserves of central
banks are denominated in USD.5
Moreover, a majority of FX transactions involve the
U.S. dollar on one side because it is usually cheaper
for parties to make payments indirectly through the
USD than directly through thinly traded currencies.
For example, exchanging Malaysian ringgits (MYR) for
Brazilian reals (BRL), in practice, actually involves two
separate trades: one from MYR to USD and another
from USD to BRL. The USD is the vehicle currency in
the exchange. Dominance by one currency has long
been a feature of the international monetary system,
because of the increased efficiencies and network
externatilities involved. Prior to World War II, for
example, the pound sterling was the world’s premier
currency, and before that, it was the Dutch gilder.
Factors impacting currency markets
The two most important factors influencing currency
prices are interest rates and inflation. Countries with
higher interest tend to attract investors, increasing
Chart 2: D
 aily turnover in the FX markets by instrument
$4,500
$4,000
Sells GBP @1.5000
to ABC Co. $3,500
Replaces GBP $3,000
inventory @$1.4996
in Billions
$2,500
$2,000
$1,500
$1,000
$500
Hedges GBP exposure
$0
by selling to Bank 1
@$1.4996
Buys GBP @$1.4995
Source: BIS
demand for the local currency and causing it to rise
in value. Conversely, lower interest rates decrease
demand and depress value.
Inflation reduces the purchasing power of a currency
and makes it less valuable. Currencies of countries
where inflation is high, generally underperform those
of countries where it is low. Other short– to long-term
variables that impact currency markets include: Gross
Domestic Product (GDP) growth, unemployment rate,
consumer confidence, balance of trade (level of
exports relative to imports), and geopolitical events.
In many ways investment in foreign exchange is an
investment in the relative growth of a country or region.
In addition to the above fundamental factors, day-to-
day FX activity is also affected by traders reacting to
technical indicators that utilize past prices and trading
volumes to predict where currencies will be in the near
future. Commonly followed technical signals include:
support and resistance support levels, moving average
crossovers, head-and-shoulder formations, etc. Tellingly,
more than 90% of FX traders report using some form of
technical analysis to make trading decisions.6
The rise of machines: the future of the FX
market
Technological advances, such as electronic trading
platforms, are transforming FX markets by reducing
transaction costs, increasing market liquidity, and
transparency, and encouraging the adoption of
new strategies, such as algorithmic trading, where
computers execute trades based on complex
mathematical rules at very high frequencies (often on
the order of hundreds or even thousands of trades per
second). The Bank of International Settlements (BIS)
estimates that algorithmic trading was responsible for
45% of the total FX turnover in 2010, up from just
2% in 2004. That figure is only expected to grow in
the future.
5
Eichengreen, B. (2011, March 1). Why the dollar’s
reign is near an end. The Wall Street Journal
6
Osler, C. (2000). Support for Resistance: Technical
Analysis and Intraday Exchange Rates. FRBNY Review
$3,980
$3,324
$1,934
$1,527
$1,190 $1,239
$820
$590
1989 1992 1995 1998 2001 2004 2007 2010
Spot Outright Foreign exchange Other
transactions forwards swaps
If foreign exchange is indeed an asset class, we can expect
currency returns to be similarly amenable to a fixed set of
rules (that is to say, we should be able to identify currency
betas). Binny (2005), Pojarliev and Levich (2007), and
Hafeez (2007), among others, have identified several styles
that help explain a significant portion of the variability
in the returns of currency managers. They include value,
carry, trend, and volatility.
Value forecasting involves using fundamental inputs,
such as inflation, interest rates, productivity growth, etc.,
to take positions in currencies that deviate from their
fair value in the expectation that they will revert back
toward their long-run equilibrium price. Traders sell the
overvalued currency and buy the undervalued one. The
concept of purchasing power parity (PPP) often serves as a
useful benchmark for determining “value” (see Box 2 for a
more detailed explanation).
The risk in this type of strategy is that currency pairs may
stay misaligned for long periods of time or even deviate
further before reverting to their mean. In some cases,
the change may even be permanent. Research shows that
value forecasting tends to work best when misalignments
are extreme (such as during periods of hyperinflation), and
is progressively less effective when deviations are smaller.
Possibly the best known currency strategy is the carry
trade. It is essentially a search for yield. Traders buy
high-interest rate currencies and sell low-interest ones,
earning the interest rate differential between them. A
great example was the AUD/JPY trade in the mid-2000s,
when the commodity-rich Australian economy was
booming on the back of surging global demand for natural
resources. Short-term interest rates in Australia stood at
4.75%. By contrast, interest rates in Japan, still recovering
from its “lost decade,” were at 0%. Currency traders took

Box 2: T he Big Mac Guide to the FX Market

Purchasing power parity (PPP) and interest rate parity
(IRP) are two fundamental concepts in exchange rate
theory.
Purchasing Power Parity
Based on the law of one price, PPP holds that in
competitive markets identical goods should have
the same price when valued in the same currency
(otherwise the opportunity for arbitrage or risk-free
returns would exist). Empirical tests of PPP often employ
hundreds of consumer items in an effort to produce a
“market basket” that is consistent across countries. But
the concept can be illustrated more easily.
The Economist magazine’s Big Mac Index is a light-
hearted but instructive application of PPP. The index
compares the price of McDonald’s famous burger
around the world with its average U.S. price to
arrive at valuations for currencies. The Big Mac is
an effective proxy for an identical basket of goods
because it is available in 120 countries and its
composition is generally the same everywhere.
For instance, in January 2012, the price of a Big
Mac was $4.20 in the U.S. and £2.48 in the U.K.
The implied PPP based on these prices is 1.69
against the USD until the price of a Big Mac is the
same as in the U.S.
Interest Rate Parity
IRP states that expected returns on deposits in
currency A must be equal to the expected returns
on deposits of the same maturity in currency B
when measured in the same currency (otherwise the
opportunity for arbitrage would exist). For example, if
interest rates on 1-year euro deposits are 5% and at
the same time 1-year U.S. dollar deposits pay 2%, we
can expect the dollar to appreciate 3% against the
euro in one year. In such a scenario investors would be
indifferent to holding either currency (5% total returns
in both cases).
On the other hand, if the expected U.S. dollar
appreciation was only 2%, then investors could
borrow in dollars, convert the loan to euros at the spot
rate, and invest the
proceeds in higher-
yielding 1-year Chart 3: L ocal currency over/under valuation against the USD, %*
euro deposits. They Switzerland
could negate the Brazil
exchange rate risk Australia
have not been effective predictors of exchange rate
movements. Studies indicate PPP works best when
deviations are at extremes (e.g., in hyper-inflation
environments) and is progressively less effective over
smaller misalignments. Violations of uncovered interest
rate parity are equally well documented. In fact, the
carry trade, described above, is possible precisely
because in many cases higher-yielding currencies
actually appreciate against lower-yielding ones. So
not only can investors profit from the interest rate
differential between the two currencies, but they can
also capture capital gains from currency appreciation.
Even so, the PPP and IRP remain powerful and
intuitive tools for understanding the FX market and is
a good starting point of any currency analyses. So the
next time you’re in Paris, London, or Dubai, step into
a McDonald’s for lunch and to get a handle on the
FX market.
6.81
5.68
4.94

(4.20/2.48). Since the actual exchange rate of Canada 4.73

and lock in the U.S. 0.00
1.54 USD/GBP was lower than the implied PPP, it 1% profit risk-free Japan (4.16)
suggested that the GBP was undervalued. According by simultaneously Britain (3.82)

to theory, the currency should appreciate until it selling a forward Turkey (3.54)

reaches the implied PPP. Mexico (2.70)

contract. Egypt (2.57)

We can make similar comparisons for other Russia (2.55)

currencies. The chart at right suggests the Swiss Gap between Indonesia (2.46)
South Africa (2.45)
franc is overvalued against the U.S. dollar, while the theor y and China (2.44)
Chinese renminbi is undervalued. Specifically, the practice -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60% 70%
index estimates that, in dollar terms, a Big Mac costs While theoretically
$6.81, or 60% more in Switzerland and just $2.44, Price in $
sound, as an
or 40% less in China. Under PPP, we would expect empirical matter Source: The Economist (http://bigmacindex.org/2012-big-mac-index.html)
*Exchange rates as of January 12, 2012.
the franc to depreciate and renminbi to appreciate PPP and IRP

WHITEPAPER 5
advantage of the difference in interest rates by going long Most currency managers employ some form of trend-
the AUD and shorting the JPY (the net interest earned or following or momentum strategy. Currencies often
“carry” would be added to the trader’s account at end of exhibit trending behavior (i.e., display serial correlation)
each day the position was held).7 that suggests past prices can be informative of future
The carry trade is a medium- to long-term investment and movements. Rather than forecast where currencies are
works best in low volatility environments. That’s because headed, trend-following managers seek to “ride” existing
traders are not only looking to buy currency pairs that trends until they reverse.8 Managers often employ
offer a positive carry but, equally, are seeking pairs where technical indicators to detect trends. One basic technique
that relationship is likely to hold or even improve. In the is the simple moving average (SMA). Applying a 50-day
AUD/JPY case, interest rates in Australia climbed to 7% SMA to the USD/JPY pair in Figure 4, an investor would
between 2003 and 2008, while essentially staying the same buy the pair anytime the exchange rate crossed its 50-day
in Japan. That growing difference in interest rates led to a moving average from below and sell it whenever price
substantial appreciation of the AUD against the JPY and crossed the same from above.
significant capital gains for carry traders. However, the Trends can endure over a wide range of time periods,
trade broke down rapidly with the onset of the financial appearing and disappearing in less than a day to lasting
crisis in late 2008, with the currency pair giving up five for months. Furthermore, not all currency pairs trend (e.g.,
years of gains in a matter of months, as shown in Figure 3. USD/CAD,USD/AUD, and EUR/CHF), and others may
do so only over certain periods. A key deficiency of trend-
following models is that they are (by necessity) backward-
Figure 3: I llustrative example of an AUD/JPY trade looking and work on the assumption that the near future
will be similar to the recent past, potentially exposing
110
105 Capital Gain: $23,500
managers to sharp market corrections and false trading
Sell AUD/JPY
100 Interest income: $25,208 signals that add to costs.
AUD/JPY Exchange Rate

95 Total Profit*: $48,708

90 Finally, volatility-based strategies are non-directional
85
80
Rush to unwind
strategies that seek to profit regardless of the direction
75
70
the carry currencies take. Just as traders utilize derivatives to take
65
60
Buy AUD/JPY advantage of the equity market’s implied volatility, traders
55 make use of equivalent measures in the FX market. One
50
45 counterpart to the well-known VIX index is Deutsche
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
Bank’s CVIX, which tracks the expected future volatility
in currency markets, and can be used to take directional
* Calculations are based on the purchase of 1 standard lot of AUD/JPY with notional of 100,000
units. We assume no leverage was used. views on FX fluctuations. Volatility strategies typically
Source: Bloomberg, IMG

Figure 4: E xample of an SMA trend-following strategy* Figure 5: V olatility in the FX market

86 90 25
80 23
84
70 21
82 60 19
DB CVIX Index

SELL signals (red) 17

USD/JPY

VIX Index

50
80 15
40
13
78 30 11
Buy 20
76 signals 9
(green) 10 7
74 0 5
Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11
USD/JPY 50-day MA VIX Index CVIX Index
* Simple moving-average. Source: Bloomberg, IMG Source: Bloomberg, IMG

7
Conceptually, all that is happening is that a trader borrows yen from a Japanese institution, converts the loan into Australian dollars (AUD), and invests in higher yielding Australian
government securities. Once the investment matures the investor converts the proceeds back into Yen to pay back the original loan.
8
For a general discussion on the why trends exists in financial markets contrary to theory, see the whitepaper Hedge Fund Strategies: A Managed Futures Primer (2011) from Merrill
Lynch Global Wealth Management

6 WHITEPAPER
involve implementing an options straddle that entails annual returns of 9.5% with a standard deviation of 6.1%
selling call or put options and collecting the premium when and maximum drawdown of 6.4% over the twelve years
managers expect currency movements to stay within a covered. Next best were trend-following strategies with 6.1%
narrow range or involves buying calls and puts to profit returns and 5.4% annualized volatility. Interestingly, the
from large swings in volatility. popular carry strategy performed on par with the volatility
strategy until 2008. Its subsequent unraveling and weaker
H OW D O T H E F X S TR ATE G I E S PE R F O R M? performance is not all surprising given that the carry-trade
In a decade marked by the bursting of two asset bubbles strategy works best in non-volatile markets. Trend-following
and increased volatility, the currency strategies described strategies, by comparison, do well in markets with clear
above performed rather well. We used four Barclays direction — up or down, but suffer in “choppy” or sideways
investable FX indexes — the Barclays Intelligent Carry, markets.
Barclays Adaptive FX Trend, Barclays FX Value, and
Barclays Tactical SBeta — as respective proxies for these T H E RO L E O F C U R R E N C I E S I N A
PORTFOLIO
styles, and examined their performance over the twelve
While the potential for enhanced returns is certainly an
year-period from 2000-2011.9 Table 2 displays the results of
attractive proposition for investors, ultimately the most
our analyses. The “FX composite” in the table is simply an
important contribution of currencies may be their ability to
equal–weighted average of these four strategies.
reduce portfolio volatility and drawdown.
The first statistic that stands out is that currencies
Harry Markowitz’s (1952) mean-variance framework
clearly outperformed equities in our sample period, which
is a good starting point for any discussion of portfolio
included both historic bull and bear markets. Moreover, the
allocation. The key lesson of Markowitz’s seminal work was
discrepancy in performance between foreign exchange and
that within a portfolio it is not essential what the risks of
stocks was higher during bear markets. Second, we see
the individual assets are, but rather what is crucial is the
that foreign exchange, as measured by the composite, has
extent to which the returns of those assets are correlated
lower volatility than equities, giving rise to substantially
with one another.
stronger risk-adjusted returns.
In that regard currencies can be particularly effective
Looking deeper, we find that within currencies, the
portfolio diversifiers. From Table 3, we can clearly see
volatility-based FX strategies performed best posting
that currencies exhibit extremely low or even negative
correlation to most other asset classes.
Table 2: F X Strategy Performance (2000–2011)
Carry Trend Value Volatility FX U.S.
Composite* Equities
Annual Returns 6.9% 6.1% 3.7% 9.5% 6.7% 1.0% Table 3: F X correlations with major asset classes
Volatility 6.1% 5.4% 5.9% 6.1% 3.3% 16.3% (2000-2011)
Sharpe Ratio 0.77 0.71 0.27 1.15 1.28 0.01
Currencies U.S. U.S. U.S. U.S. High Commodities Cash
Max Drawdown -19.7% -6.2% -16.4% -6.4% -3.9% -50.9%
Bonds Credit Equity Yield
Kurtosis 0.39 0.30 6.34 2.40 0.48 0.69
Currencies 1.00
Skew -0.29 0.03 1.13 0.47 -0.18 -0.45
U.S. Bonds -0.06 1.00
Returns (Volatility)
U.S. Credit -0.05 0.87 1.00
2000-2003 14.8% 12.1% 10.5% 14.0% 13.0% -4.2%
(6.0%) (5.7%) (4.9%) (7.8%) (3.3%) (17.9%) U.S. Equity -0.04 -0.08 0.19 1.00

2004-2007 8.9% 3.9% 2.4% 9.7% 6.3% 9.2% U.S. High Yield -0.07 0.15 0.51 0.65 1.00
(5.9%) (5.1%) (5.4%) (4.0%) (2.9%) (7.6%) Commodities 0.05 -0.01 0.13 0.30 0.28 1.00
2008-2011 -2.1% 2.7% -1.1% 5.1% 1.2% -1.6%
Cash 0.25 0.07 -0.03 -0.06 -0.15 0.02 1.00
(5.5%) (5.1%) (6.8%) (5.9%) (3.1%) (20.6%)
Source: Bloomberg, IMG. Currencies, US Bonds, US Credit, US Equity, US High Yield, Commodities,
Source: Bloomberg, IMG. Carry, Trend, Value, and Volatility indexes represented by Barclays Intelligent and Cash are represented by the FX Composite calculated in Table 2, BarCap US Aggregate Bond
Carry USD, Barclays Adaptive FX Trend TR, Barclays FX Value Convergence, and Barclays Tactical Index, BarCap US Aggregate Credit Index, S&P 500 Index, BarCap US Corporate High Yield Index,
SBeta Indexes, respectively. *FX Composite based on the equal-weighted average of the four SP Goldman Sachs Commodities Index, and Citigroup 3 Month Treasury Bill Index, respectively.
strategies described above.
Past performance is no guarantee of future results.
Past performance is no guarantee of future results.

Full definitions of these strategies are available in the glossary at the end of this report.
9

WHITEPAPER 7
 just with other assets, but also with each other. We found
Figure 6: 1
 2-month rolling correlations of the S&P 500 with that the average pair-wise correlation of the four currency
other assets (2001-2011)
strategies was just 0.10 from 2000 through 2011.
1.00
0.80 An oasis of liquidity
12 Month Rolling Correlations

0.60
0.40
Another characteristic of currencies that should be very
0.20 appealing to investors is the liquidity of the FX market.
0.00 During the last credit crisis, many financial markets
-0.20
experienced significant disruptions and spikes in volatility.
-0.40
-0.60 While bid-ask spreads on major currency pairs did rise,
-0.80 much of the FX market functioned relatively smoothly
-1.00
during the crisis. In fact, according to the Bank of
01

02

03

04

05

06

07

08

09

10

11

12
International Settlements (BIS), many investors turned to
n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-
Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Global Credit Currencies
Crisis Global HY (USD)
Source: Bloomberg, IMG. Currencies, commodities, global equities, and global high yield
represented by the FX composite as defined on page 7, SP Goldman Sachs Commodity
Index, MSCI AC World Index xUS, and BofA ML Global High Yield USD Index, respectively. Past
performance is no guarantee of future results.
Yet, readers who remember the global panic of 2008 may be
skeptical of the value of average correlations.10 If the true
test of an asset’s independence is how they relate to other
assets in turbulent markets, currencies pass. As Figure
6 highlights, even traditionally uncorrelated assets such
as commodities and high-yield debt can begin to move in
lockstep with traditional assets in volatile markets. By
comparison, correlation between currencies and the S&P
500 turns more negative the greater the stress on the
financial markets. It is not surprising then that currencies
have easily outperformed both stocks and bonds during
bearish periods in both the equity and fixed-income
markets, as shown in Figure 7.
No less important for diverfication purposes is the fact that
currency strategies themselves display low correlations not
Ja
Commodities the FX market to hedge risks in other asset classes with
Global Equities
limited market liquidity. For instance, investors reportedly
attempted to hedge losses in U.S. equities by purchasing
the Japanese yen (which was gaining as the carry trade
was being unwound). Unlike in other financial markets,
where participants may choose to sit on the sidelines
during periods of high uncertainty, staple players of the
FX market such as corporations, governments, tourists,
etc., (liquidity-seekers) do not enjoy the same luxury. The
FX market essentially has “captive” participants, whose
presence allows investors to realize gains even in the most
difficult circumstances.
Quantifying the portfolio impact of currencies
To demonstrate how foreign exchange can affect the risk
and returns of a conventional portfolio, we examined the
performance of a portfolio of U.S. stocks and bonds with
different allocations to currencies from 2000 through
2011. This particular period includes both historic bull and
bear markets and is helpful in highlighting the impact of
currencies over different segments over the market cycle.

Figure 7: P
 erformance during the worst U.S. stock and bond periods (2000–2011)
4% 1%

2%
Average Monthly Returns

0%
Average Monthly Returns

0%
-2% -1%
-4%
-1%
-6%
-8% -2%
-10%
-12% -2%
Bottom 20% Bottom 10% Bottom 5% Bottom 20% Bottom 10% Bottom 5%
Monthly U.S Stock Returns Monthly U.S Bond Returns
FX Composite S&P 500 FX Composite BarCap

Source: Bloomberg, IMG. Past performance is no guarantee of future results.

We are reminded of the cautionary tale of the statistician who drowned while crossing a river that was on average just three feet deep.
10

8 WHITEPAPER
For our analysis we used an equal-weighted composite of G A I N E X P O S U R E TO C U R R E N C I E S
the four common FX styles described previously. Our analyses confirm many academic findings that
From Table 4, we can see that adding foreign exchange currencies can be an effective diversifying agent. The question
enhanced returns and reduced portfolio volatility in all then is, how do investors actually allocate to foreign exchange?
cases. In addition, risk-adjusted returns rise progressively In years past, there were few direct options. Foreign exchange
higher with higher allocations to currencies. For example, was the domain of institutional investors, where currency
in the case of a $1 million portfolio, a 20% allocation to pairs were traded in lots whose minimum investment size
currencies at the beginning of 2000 would have increased was prohibitive to all but the biggest investors. Fortunately,
total portfolio returns by approximately $125,000 by the an important transformation in the FX market in recent years
end of 2011. has been its increased accessibility. Technological innovation
and product development now provide investors with a variety
of channels into foreign exchange.
Table 4: B
 enefits of adding FX to a traditional 60:40 portfolio
Traditional 10% FX 15% FX 20% FX Here, we list the basic ways investors can take on currency
Portfolio Allocation Allocation Allocation exposure. A common but indirect way is through the
U.S. Bonds 40% 36% 34% 32%
purchase of foreign securities. The returns on any foreign
U.S. Large Cap Equities 60% 54% 51% 48%
stock or bond have two components that can be viewed
Currencies 0% 10% 15% 20%
as “assets” within a portfolio: performance of the asset
Annualized Return 3.5% 3.9% 4.0% 4.2% itself and the change in exchange rate relative to the
Annualized Volatility 2.8% 2.5% 2.4% 2.2% home currency. How important is latter? Historically,
Max Drawdown -33% -29% -28% -26% FX volatility has contributed more than 35% of the total
Return/unit of Volatility 1.27 1.55 1.71 1.89 volatility of an international equity portfolio and more than
Source: Bloomberg, IMG 70% of the volatility of an international bond portfolio.12
To hedge or not to hedge?
For a more robust and forward-looking outlook on the To complicate matters, individual currencies can have
effects of incorporating currencies into a traditional diverse and often complex relationships with local and
portfolio, we ran a 10-year Monte Carlo wealth simulation international financial markets. Certain currencies, such as
(utilizing 10,000 iterations). The resulting probability the U.S. dollar or Canadian dollar, are generally negatively
distributions confirm our previous empirical analysis. correlated with both local and global equity markets.
Assuming the same $1 million initial investment, the Others, such as the euro and yen, on the other hand tend
median terminal value for a traditional portfolio was to be positively correlated (see Table 5). In general, when
$1,464,000 for a portfolio with 10% FX allocation and correlations between these two components are negative
$1,408,000 for a 60:40 portfolio of stocks and bonds. (positive), foreign investors realize a lower (higher) volatility
Moreover, the simulations provide us with better insight compared to their local counterparts in the same security.
into the ability of currencies to mitigate “fat-tail” events
or the risk of large-scale losses. For this purpose, we use
Table 5: C
 orrelations of major currency pairs with world
Conditional Value at Risk (“CVaR”) as our measure of risk, equity markets
calculated by averaging the worst 1% of losses from our Dollar Japanese British Swiss Canadian Australian
Euro
10,000 scenarios.11 We find that a 10% allocation to foreign Index Yen Pound Franc Dollar Dollar

exchange can help reduce significant downside risk by 9%. S&P 500 -0.19 0.17 0.21 0.18 -0.05 -0.48 0.53
Euro Stoxx 50 Price -0.11 0.07 0.25 0.13 0.08 -0.43 0.44
Our results suggest that there is potentially ample scope Nikkei 225 -0.15 0.11 0.23 0.20 -0.01 -0.38 0.47
for investors to improve their portfolio’s risk-return profile FTSE 100 -0.14 0.11 0.25 0.11 0.04 -0.46 0.49
by introducing a small amount of foreign exchange. Swiss Market Index -0.05 0.00 0.27 0.11 0.16 -0.32 0.39
S&P/TSX Composite -0.23 0.20 0.16 0.23 -0.09 -0.47 0.54
S&P/ASX 200 -0.21 0.17 0.19 0.24 -0.05 -0.42 0.48
MSCI ACWI -0.36 0.32 0.15 0.33 -0.15 -0.59 0.65

Source: Bloomberg, IMG

Additionally, CVaR overcomes a key drawback of standard deviation by capturing only downside risk and investors’ asymmetric aversion to losses.
11

State Street Global Advisors industry estimates, 2009

12

WHITEPAPER 9
Naturally, the decision to hedge FX risk will depend on the
particular investor’s base currency. For example, over the
last 35 years U.S. residents investing abroad could have
reaped on average an additional 2% per year from the
secular decline in the dollar, as measured by the trade-
weighted U.S. dollar index. (Of course, within this larger
decline, there have been significant bullish trends in the
U.S. dollar that have hurt domestic investors, most recently
during the 2007-2009 global credit crisis).
Currency overlay techniques attempt to manage such risks
by hedging exposure when foreign currencies are expected
to weaken and by allowing exposure to work in their favor
when foreign currencies are expected to strength relative
to the home currency. Conveniently, such returns are easily
“portable,” allowing investors to add a currency overlay to
almost any type of portfolio.
Growing array of foreign exchange products
More directly, investors may choose to gain FX exposure
through individual trading accounts, exchange-traded
funds, and a growing array structured products, and
investible indexes.
In the last decade, technological advances have spawned
numerous online FX trading platforms geared toward
individual investors, who are now the fastest growing
segment of the FX market. Daily retail trading volume
jumped to $313 billion in 2010 from just $300 million
in 2000. Today, customers can trade over 50 different
currency pairs with minimum account balances as low as
a few dollars.13 Furthermore, investors have the option of
trading not just individual currencies but also a basket of
currencies through various FX indexes. Currency baskets
diversify FX exposure across multiple currencies through
a single investment, and allow investors to more efficiently
express broad macroeconomic views.
There are also synthetic products that attempt to replicate
common FX styles such as the investible carry, value,
and momentum indexes using a combination of cash and
derivatives. The advantage of these rules-based currency
products is that they offer a cost-effective way to access
forms of currency returns that were not previously
available except through expensive and often illiquid,
actively managed investment vehicles. To be sure, they can
prove very profitable in certain environments, but also very
expensive in others (as in our AUD/JPY example).
For investors with more specific needs, structured products
can offer defined rates of return linked to the performance
of designated currency pairs or baskets. Typically, these
products have a fixed maturity and are comprised of a
fixed-income component and a derivative component.
Currency-linked products can also feature varying degrees
of capital protection that allow investors to participate in

Table 6: C
 omparing different vehicles to access currencies
Mgmt Style Potential Benefits Potential Drawbacks
Foreign stocks Passive Liquidity Exposure to equity market risk
Dividends Stock-specific risk exposure
Foreign bonds Passive Liquidity Interest-rate risk
Income Credit risk of issuer
FX indexes (currency Passive Efficiently express macro views on multiple countries or an entire No alpha generation
baskets) region Interest-rate risk
Simultaneous hedging of multiple currencies through options
FX structured products Passive Customizable No alpha generation
Accessible to most investors Capped upside gains
May offer some principal protection Interest-rate risk
ETFs/ ETNs Passive Liquidity No alpha generation
Accessible to most investors ETNs subject to credit risk
Currency derivatives Active Liquidity Not accessible to all investors
Leverage (up to 100:1)
Commodity Trading Active Potential for alpha Not a pure play on currencies as mandate extends beyond FX
Advisors (CTAs) Transparent Poor liquidity and not accessible to all investors
Global macro funds Active Potential for alpha Mandate extends beyond FX
Able to utilize wide array of instruments to execute trades Illiquid and not accessible to all investors
Tax inefficient
Manager selection critical
Currency-specialist Active Deep expertise in currencies Less fund diversification
hedge funds Able to utilize wide array of instruments to execute trades Illiquid and not accessible to all investors
Tax inefficient
Manager selecion critical
Source: IMG

Bernard, L. S. (2011, July 9). Is Currency Trading Worth the Risk? The Wall Street Journal.
13

10 WHITEPAPER
some of the upside potential of a currency basket, while
helping to preserve capital in difficult periods.
But, by far, the most popular way to invest directly in
currencies in recent years has been through currency-
based exchange traded funds (ETFs). These vehicles trade
like equities and are designed to capture exchange rate
fluctuations. Depending on the investor’s objective, ETFs can
provide exposure to either a single currency or a basket of
currencies, with or without significant leverage. Exchange-
traded currency notes, or ETNs, are similar in function to
ETFs except they are actually debt notes that carry the credit
risks of the issuer and are taxed less favorably.
“Alpha hunters” over “beta grazers?”
If investors want additional returns unrelated to the beta
strategies discussed earlier, they should consider actively
managed currency funds. Active currency managers seek
to capture currency market alpha through investment
flexibility and effective risk management. Whereas beta is
representative of returns available from general trends in
the market, alpha is a reflection of an individual manager’s
skills (commonly measured as the returns in excess of a
benchmark). A currency manager can earn alpha through
a variety of ways, including:
■■ Opportunistically
choosing which currency pairs to
trade and which currency strategies to employ
■■ Adeptly weighting those positions in a portfolio
■■ Selecting
the most efficient financial instruments to
establish positions and execute trades
■■ Timing
when to enter and exit trades
■■ Competentlymanaging portfolio risks, including the
use of leverage
Active currency managers can include mutual funds,
hedge funds, and commodity-trading advisors (CTAs).
However, they come at a cost. Hedge funds and CTAs,
for example, generally charge fees of 2% of assets under
management and 20% of profits, are generally not very
liquid, and often require large investment minimums.14
Moreover, there can be large discrepancies in the
performance of the managers themselves, highlighting the
importance of identifying the “right” managers.
S O M E R I S K S TO C O N S I D E R
While foreign exchange can offer significant portfolio
benefits, readers should understand that investing in
currencies also involves considerable risk and may not be
Many hedge funds offer investors, at best, only quarterly redemptions, may require investors to lock up their investments for 1-2 years, and have minimum investments of $100,000 or more.
14
WHITEPAPER 11
suitiable for all investors. Given the size of the FX market
and the propensity for small daily changes in exchange
rates, exposure to currencies often involves significant
use of leverage to make trades sufficiently profitable —
anywhere between 50-100x the initial investment. While
leverage can significantly enhance returns when currency
pairs behave as anticipated, it can also have far more
damaging effects if a trade turns sour.
Investors also need to be aware of certain nuances of
the FX market. Unlike in other markets, government
intervention in the FX market is not an uncommon
occurrence. Central banks will from time to time intervene
in the open market to effect change in the price of their
currency to implement certain economic objectives. Such
interventions can have immediate and considerable impact
on the FX markets.
Besides exogenous factors like government intervention,
the FX market is also prone to herding effects. As FX
trading is often limited to a handful of currency pairs, it
can lead to investors pursuing similar trades, that can
become very crowded — e.g., the AUD/JPY carry. When
fundamentals warrant a small change in the price of
the currencies, a wave of selling may occur as investors
seek to unwind the trade ahead of others (and is usually
exacerbated by the use of leverage).
CONCLUSION
The foreign exchange market is the largest and most liquid
financial market in the world. It is also one of the most
poorly understood and underexploited markets. While the
role of currencies has traditionally been limited to hedging
FX risks and speculation, there is now a growing consensus
that currencies can also make good portfolio investments.
A large body of evidence suggests that the heterogeneity
of the FX market gives rise to inefficiencies that can be
systematically exploited. Data from the last twelve years show
currencies handily outperforming equities both nominally
and on a risk-adjusted basis. While returns are important,
possibly the greater appeal of currencies is their ability to
reduce portfolio volatility and limit drawdown. Currencies
exhibit low correlation to traditional assets throughout the
market cycle, even during periods of extreme market stress.
For these reasons, we believe that understanding the
dynamics of the FX market and making informed
allocations to currencies can help investors better navigate
difficult markets.
REFERENCES Markowitz, H. (1952). Portfolio Selection. Journal of Finance, Vol. 7 (1), 77-91.

Bernard, L. S. (2011, July 9). Is Currency Trading Worth the Risk? The Wall Street Nadig, D. , Hougan, M. & Crigger, L. (2009). Currencies: The Overlooked Asset Class.
Journal. Journal of Indexes, 10-18.

Binny, J. (2005). Currency Management Style through the Ages. The Journal of Nasypbek, S. & Rehman, S. S. (2011). Explaining the returns of active currency
Alternative Investments, Vol. 8 (3), 52-59. managers. BIS Papers No. 58. http://www.bis.org/publ/bppdf/bispap58j.pdf

Currency Management in a Volatile World (2012). State Street Vision Series.
Eichengreen, B. (2011, March 1). Why the dollar’s reign is near an end. The Wall
Street Journal.
Hafeez, B. (2007). Currency Markets: Money Left on the Table? Deutsche Bank.
Hafeez, B. (2007). Currency Indices in a Portfolio Context. Deutsche Bank.
Harris, L. (1993). The Winners and Losers of the Zero-Sum Game: The Origins of
Trading Profits, Price Efficiency and Market Liquidity. Institute for Quantitative
Research in Finance Spring 1993 Seminar. Wesley Chapel, FL.
King, M. R., Osler C. & Rime, D. (2011). Foreign exchange market structure, players
and evolution. Norges Bank.
King, M. R. & Dagfinn, R. (2010, December). The $4 trillion question: what explains
FX growth since the 2007 survey? BIS Quarterly Review, 27-42.
Osler, C. (2008). Foreign Exchange Microstructure. Encyclopedia of Complexity and
System Science.
Osler, C. (2000). Support for Resistance: Technical Analysis and Intraday Exchange
Rates. Federal Reserve Bank of New York Review, Vol. 6 (2), 53-68.
Pakko, M. R. & Pollard, P. S. (2003). Bugernomics: A Big MacTM Guide to Purchasing
Power Parity. The Federal Reserve Bank of St. Louis Review.
Pojarliev, M. and Levich, R. (2007). Do Professional Currency Managers Beat the
Benchmark? NBER Working Papers 13714, National Bureau of Economic Research,
Inc. http://www.nber.org/papers/w13714.pdf

This document was prepared by GWIM Investment Management & Guidance (IMG) and is not a publication of BofA – Merrill Lynch Global Research. Global Wealth & Investment
Management (“GWIM”), a division of Bank of America Corporation, includes the GWIM Investment Management & Guidance (“GWIM IMG”), which provides industry-leading investment
solutions, portfolio construction advice and wealth management guidance. The views expressed are those of GWIM IMG only and are subject to change. This document is neither
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kind, a solicitation of clients, or an offer to sell or a solicitation of an offer to invest in alternative investments. An investment in an alternative investment may be offered only pursuant
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This document was issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and does not contain investment
recommendations. The opinions expressed are as of 6/30/2012, and are subject to change without notice. There is no guarantee that views and opinions expressed in this
communication will come to pass.

IMPORTANT DISCLOSURE INFORMATION

Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or its securities. It should not be assumed
that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.
Some or all alternative investment programs may not be suitable for certain investors. No assurance can be given that any alternative investment’s investment objectives will be
achieved. Many alternative investment products are sold pursuant to exemptions from regulation and, for example, may not be subject to the same regulatory requirements as mutual
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alternative investments require tax reports on Schedule K-1 to be prepared and filed. As a result, investors will likely be required to obtain extensions for filing federal, state, and local
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high degree of risk, including leveraging strategies and other speculative investment practices that may increase the risk of investment loss, including the principal value invested.
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derivatives, including swaps, OTC contracts, and futures and forwards, can be substantial. There is no guarantee that this objective will be achieved. The use of hedging strategies may,
in certain circumstances, cause the value of a portfolio to appreciate or depreciate at a greater rate than if such techniques were not used, which in turn result in significant loss.
Diversification: Diversification does not ensure a profit or protect against loss in declining markets.
Hedge Funds: Hedge funds are speculative and involve a high degree of risk. An investor could lose all or a substantial amount of his or her investment. There is no secondary market
nor is one expected to develop for investments in hedge funds and there may be restrictions on transferring fund investments. Hedge funds may be leveraged and performance may
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managed to historic volatility ranges by the funds, investors should note that they are investing in securities on a leveraged basis. Be sure to read the entire Confidential Program
Disclosure Document as defined, which contains information concerning risk factors, conflicts, performance information and other material aspects.

12 WHITEPAPER
Options: Options can carry a high level of risk and are not suitable for all investors. Investors should take special precautions to ensure that they understand thoroughly the risks
associated with options before engaging in option transactions. Because each option transaction produces a tax consequence, clients should discuss with their tax advisors how the
options transactions and any sales of underlying stock will affect their tax situation before investing.
Investors should bear in mind that the global financial markets are subject to periods of extraordinary disruption and distress. During the financial crisis of 2008-2009, many private
investment funds incurred significant or even total losses, suspended redemptions or otherwise severely restricted investor liquidity, including increasing the notice period required for
redemptions, instituting gates on the percentage of fund interests that could be redeemed in any given period and creating side-pockets and special purpose vehicles to hold illiquid
securities as they are liquidated. Other funds may take similar steps in the future to prevent forced liquidation of their portfolios into a distressed market. In addition, investment funds
implementing alternative investment strategies are subject to the risk of ruin and may become illiquid under a variety of circumstances, irrespective of general market conditions.
This material contains forward-looking statements about plans and expectations for the future. These statements may be identified by the use of words such as “may,” “will,” “expect,”
“anticipate,” “estimate,” “believe,” and “continue.” These statements are based on current plans and expectations. There is always the risk that actual events may differ materially from
those anticipated and that the forward-looking views may not come to pass. No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii)
distributed to any person that is not an employee, officer, director, or authorized agent of the recipient, without the prior written consent of Merrill Lynch.
Nothing herein should be construed as an offer or recommendation or solicitation of any products and services by Merrill Lynch. The information provided herein is intended for general
circulation and does not have regard to the specific investment objectives, the financial situation and the particular needs of any specific person who may receive this information.
Recipients should seek the advice of their independent financial advisor before considering information herein in connection with any investment decision, or for a necessary
explanation of its contents.
In respect of certain investments, companies in the Merrill Lynch group have or may have a position or a material interest in any one or more of those investments and Merrill Lynch
is or may be the only market maker for such investments. Merrill Lynch, as a full service firm, may have, or may have had within the previous 12 months, business relationships with
or provided significant advice to providers of products and services mentioned.
Some products and services may not be available in all jurisdictions or to all clients

INDEX DEFINITIONS
Indexes are unmanaged and their returns do not include sales charges or fees, which would lower performance. It is not possible to invest directly in an index. They are included here
for illustrative purposes. Performance represented by a hedge fund index is subject to a variety of material distortions, and investments in individual hedge funds involve material
risks that are not typically reflected by an index, including the “risk of ruin.” The indexes referred to herein do not reflect the performance of any account or fund managed by Merrill
Lynch or its affiliates, or of any other specific fund or account, are unmanaged and do not reflect the deduction of any management or performance fees or expenses. One cannot
invest directly in an index.
Barclays Aggregate Bond Index: The Barclays Aggregate Bond Index comprises of government securities, mortgage-backed securities, asset-backed securities, and corporate
securities to simulate the universe of bonds in the market. The maturity of the bonds in the index is over one year.
Barclays FX Value Convergence Index: The index takes long and short positions in G10 currencies. The underlying portfolio rebalances on a monthly basis, taking long positions in
currencies that appear undervalued against their PPP level, and short positions in overvalued currencies.
Barclays Capital Adaptive FX Trend Index: The index takes long and short positions in G10 currencies based on the direction of trend and individual currency pair volatility. The index
is rebalanced daily and has a target volatility of 5%.
Barclays Capital Tactical SBetaVol Index: The index uses a systematic ranking model to determine the weights of each of the forward volatility agreements in the index. The ranking
model generates buy or sell signals based on the expected return of each asset taking trading costs into account.
Barclays Capital Intelligent Carry Index: The index seeks to capture returns from the “carry trade” among the G10 currencies through interest rate differentials and forward bias. The
index is mean variance optimized, rebalanced monthly and constrained to a target volatility of 5%.
Barclays Currency Traders Index: An equal-weighted index of managed programs that trade currency futures and/or cash forwards in the inter bank market. As of 2012, there are
currently 108 managers included in the index.
Barclays US Corporate High Yield Total Return Index: The Barclays US Corporate High Yield TR Index is comprised of fixed-rate, publicly issued, non-investment grade debt.
BofA ML Global High Yield USD Index: The index tracks the performance of USD, CAD, GBP and EUR denominated below investment grade corporate debt publicly issued in the
major domestic or eurobond markets.
Deutsche Bank Currency Volatility Index (CVIX) is the Deutsche Bank Currency Volatility Index. Similarly to the Chicago Board Options Exchange Volatility Index (VIX), which measures
the implied volatility of equity markets (based on the S&P 500), CVIX measures the implied volatility of currency markets. Thus, it is a measure of the market’s expectation of future
currency volatility and can be used as a benchmark of risk appetite. In order to give a broad representation of expected future volatility in currency markets, CVIX is calculated based
on a the 3m implied volatilities of 9 major currency pairs. The currency pairs and their weights are listed below: EURUSD 35.90% USDJPY 21.79% GBPUSD 17.95% USDCHF 5.13%
USDCAD 5.13% AUDUSD 6.14% EURJPY 3.85% EURGBP 2.56% EURCHF 1.28% CVIX contracts trade as futures.
MSCI AC World Index: The index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging
markets. It consists of 45 country indexes comprising of 24 developed and 21 emerging market country indexes.
S&P 500 Index: The S&P 500 Total Return Index is a market-weighted index that measures the total return, including price and dividends, of 500 leading companies in leading
industries of the U.S. economy. This index is often used as a reference for the performance of the U.S. equities market.
S&P Goldman Sachs Commodity Index (GSCI): The Goldman Sachs Commodity Index is composed of futures contracts on 24 physical commodities. It reflects the return on fully
collateralized future positions. The index is calculated primarily on a world production-weighted basis and is comprised of the principal physical commodities that are the subject of
active, liquid futures markets.
The indexes referred to in the paper do not reflect the performance of any account or any specific fund, and do not reflect the deduction of any management or performance fees,
or expenses. One cannot invest directly in an index. The indexes shown are provided for illustrative purposes only. They do no represent benchmarks or proxies for the return of any
particular investable product. The alternative universe from which the components of the indexes are selected is based on funds that have continued to report results for a minimum
period of time. This prerequisite for fund selection interjects a significant element of “survivor bias” into the reported levels of the indexes, as generally, only successful funds will
continue to report for the required period, so that the funds from which the statistical analysis or the performance of the indexes to date is derived necessarily tend to have been
successful. There can, however, be no assurance that such funds will continue to be successful in the future.
Merrill Lynch assumes no responsibility for any of the foregoing performance information, which has been provided by the index sponsor. Neither Merrill Lynch nor the index sponsor
can verify the validity or accuracy of the self-reported returns of the managers used to calculate the index returns. Merrill Lynch does not guarantee the accuracy of the index returns
and does not recommend any investment or other decision based on the results presented.

WHITEPAPER 13
TECHNICAL TERMS
Alpha: The difference in return above or below the return of a target index.
Beta: A measure of the sensitivity of the returns of the fund to the comparative index. For example, a Beta of 2.0 would indicate that for every 1% move up in the comparative index,
the fund moved up 2% on average.
Bull Market: A condition marked by increased confidence and optimism in the market as reflected in the rising prices of securities. Many consider a 20% or more rise in prices in
multiple broad market indexes a bull market.
Correlation: Measures the extent of linear association of two variables. It quantifies the extent to which the fund and a comparative index move together.
Efficient Frontier: The “efficient frontier” tracks the relationship of rate of return and performance volatility (as measured by standard deviation). While performance volatility is one
widely accepted indicator of risk in traditional investment strategies, in the case of alternative investment strategies, performance volatility is an indicator of only one dimension
of the risk to which these actively managed, skill-based strategies are subject. There is a “risk of ruin” in these strategies, which has historically had a material effect on long-term
performance but which is not reflected in performance volatility. From time to time, extremely low volatility alternative investments have incurred sudden and material losses.
Consequently, any comparison of the e­ fficient frontiers of traditional and alternative investments is inherently limited. In addition, any comparison of actively managed strategies and
passive securities indexes is itself subject to inherent material limitations, as is the selection of what index should be used as representative of alternative investment strategies.
Tail risk (fat-tail): Defined as scenarios in which an asset or portfolio moves more than three standard deviations from its current price.
Futures: A contract obligating the buyer to buy an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and
price. Futures contracts are standardized contracts that trade over an exchange.
Kurtosis: A statistical concept that describes the shape, more specifically the “peakedness,” of a probability distribution.
Max Drawdown: A term used to describe a peak to trough decline during a specific time period.
Monte Carlo Simulations are the result of running a large number of random scenarios in an attempt to determine the most probable performance results of a given portfolio.
These simulations may be based not only on past performance information, which is not indicative of future results, but they may also be based on hypothetical performance for
certain periods and for certain underlying funds or accounts. Monte Carlo simulations do not purport to represent the actual performance of any account, but attempt to indicate
the most repeated hypothetical performance results of a large number of different hypothetical accounts. No actual account has performed in the manner indicated in the Monte
Carlo simulations, and the hypothetical scenarios used in the simulation may omit entire categories of relevant scenarios. There can be no assurance that any given account will
in fact perform in a manner materially consistent with the probabilities indicated by the simulation. No representation is or could be made that the probabilities indicated by
these simulations are based on any fundamental economic or market characteristics, and in the absence of such characteristics, there is no reason that these probabilities will be
representative of any actual account.
Sharpe Ratios and Standard Deviation of returns are commonly used measures of the risk-reward profile of traditional portfolios and broad market indexes. However, these statistics
may materially understate the true risk profile of a fund because hedge funds are subject to a “risk of ruin” which may not be reflected in the standard deviation of returns. The
markets in which hedge funds trade, the liquidity characteristics of the traded securities, the risks of leverage, the use of derivative securities with nonlinear risk sensitivities, the use
of nonrepresentative historical data for estimating standard deviation, manager error, bad judgment and/or misconduct create the possibility of sudden, dramatic, and unexpected
losses — losses that may not be adequately reflected in Sharpe ratios or standard deviations. Prospective investors must recognize this risk of ruin, which is a material risk involved
in investing in any alternative investment, and which may not be adequately reflected in such performance statistics as the Sharpe ratio.
Short: The sale of a borrowed security with the expectation that the security will fall in value and the borrower will be able to purchase the security at a lower price.
Straddle: An options strategy in which the investor holds both a call and a put with the same strike price and expiration date anticipating volatility in the underlying security.
VIX (Chicago Board Options Exchange Volatility Index): An index that measures 30-day expected volatility of the market (S&P 500 Index). The VIX is a commonly used measure of
market risk.

Recent Publications from Investment Management & Guidance

July 2012 Non Traditional Mutual Funds Sussman
July 2012 Hedge Fund Due Diligence Kosoff
June 2012 Commercial Real Estate Bowden/ Smith
Spring 2012 What Behavioral Finance Has to Say About Generations X, Y and Z Liersch
Spring 2012 Innovations in Behavioral Finance: How to Assess Your Investment Personality Liersch/Suri
Spring 2012 Dynamic Asset Allocation Suri/Almadi/Maclean

14 WHITEPAPER
 THE CIO TEAM
Lisa Shalett,
GWIM CIO and Head of Investment Management & Guidance
lisa.shalett@ml.com • 212-449-0544

Spencer Boggess, Tom Latta, Anil Suri, Chris Wolfe,

CIO, Alternative Investments Global Head, Traditional Manager Due Diligence CIO, Multi-Asset Class Modeled Solutions CIO, PBIG and Ultra-High Net Worth Customized
212-449-3043 201-557-0258 212-449-3385 Solutions
212-236-3159

Jim Russell, Rick Galiardo, Bill O’Neill, Victoria Ip,

CIO, Portfolio Construction and Multi-Manager Global Head, Advice, Guidance and Research CIO, EMEA Chief Investment Strategist, Asia-Pacific Rim
Solutions Strategy 44-20-79955745 852-3508-5305
201-557-0079 212-449-3348

I M P O R TA N T D I S C L 0 S U R E I N F O R M ATI O N
This piece was prepared by the GWM Investment Management & Guidance (“IMG”). The views expressed are those of IMG. This is not a publication of BoA-Merrill Lynch Global Research.
In addition, these views are subject to change. This material contains forward-looking statements about plans and expectations for the future. These statements may be identified by
the use of words such as “may,” “will,” “expect,” “anticipate,” “estimate,” “believe,” and “continue”. These statements are based on current plans and expectations. There is always the
risk that actual events may differ materially from those anticipated and that the forward-looking views may not come to pass. This document is current as of the date noted, is solely for
informational purposes and does not purport to address the financial objectives, situation or specific needs of any individual reader. Market information provided herein was generally prepared
by sources unrelated to Merrill Lynch. Such information is believed to be reasonably accurate and current for the purposes of the illustrations provided but neither Merrill Lynch nor any of its
affiliates has independently verified this information. Opinions and estimates expressed herein are as of the date of the report and are subject to change without notice. Neither the information
nor any opinion expressed represents a solicitation for the purchase or sale of any security.
Any statements regarding market events, future events or other similar statements constitute only subjective views, are based upon expectations or beliefs, should not be relied on, are subject
to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or
quantified and are beyond Merrill Lynch’s control. Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these statements. In light of
these risks and uncertainties, there can be no assurance that these statements are not or will not prove to be accurate or complete in any way.
This document is provided for informational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any securities and any such offering will occur only upon
receipt of and in accordance with the terms and conditions set forth in the offering documents. The document is not intended for distribution to, or use by, any person or entity in any jurisdiction
or country where such distribution or use would be contrary to local law or regulation.
The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This document does not take into account your
particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or
strategy. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.
Alternative investments are intended for qualified and suitable investors only. Alternative Investments such as derivatives, hedge funds, private equity funds, and funds of funds can
result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest
in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, and your tolerance for risk. Alternative
Investments are speculative and involve a high degree of risk.
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or
investment advice.
There may be conflicts of interest relating to the alternative investment and its service providers, including Bank of America, and its affiliates, who are engaged in businesses and have
clear interests other than that of managing, distributing and otherwise providing services to the alternative investment. These activities and interests include potential multiple advisory,
transactional and financial and other interests in securities and instruments that may purchase or sell such securities and instruments. These are considerations of which investors in the
alternative investments should be aware. Additional information relating to these conflicts is set forth in the offering materials for the alternative investment.
Investors should bear in mind that the global financial markets are subject to periods of extraordinary disruption and distress. During the financial crisis of 2008-2009, many private
investment funds incurred significant or even total losses, suspended redemptions or otherwise severely restricted investor liquidity, including increasing the notice period required for
redemptions, instituting gates on the percentage of fund interests that could be redeemed in any given period and creating side-pockets and special purpose vehicles to hold illiquid
securities as they are liquidated. Other funds may take similar steps in the future to prevent forced liquidation of their portfolios into a distressed market. In addition, investment funds
implementing alternative investment strategies are subject to the risk of ruin and may become illiquid under a variety of circumstances, irrespective of general market conditions.
Economic and market forecasts presented herein reflect our judgment as of the date of this document and are subject to change without notice. These forecasts do not take into account
the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject
to high levels of uncertainty that may affect actual performance. Accordingly, based on assumptions, and are subject to significant revision and may change materially as economic and
marketing.
No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director or authorized agent
of the recipient, without Merrill Lynch’s prior written consent.
© 2012 Bank of America Corporation. All rights reserved. ARS621Q5

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