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

KEY IMPLICATIONS

SULTAN KHAN, AVP, PORTFOLIO STRATEGIES DESK

ANIL SURI, CIO, MULTI-ASSET CLASS MODELED SOLUTIONS

The global economic crisis of 2008 was a humbling and painful experience
for many. In its wake, more than ever investors are seeking non-correlated
assets that can deliver consistent returns and help protect against downside
risks. One such type of asset that is familiar to everyone, but is typically not
thought of as an investment, is currencies.

The foreign exchange (FX) market is the

largest and most liquid financial market
in the world, playing a critical role in the
functioning of the global ecoonomy.
Uses of foreign exchange
Governments, corporations, institutions,
and individuals are all, directly or
indirectly, players in the vast FX market.
They utilize currencies for a variety of
reasons both mundane and exotic. Four
basic uses are:

1. For transactional purposes

2. As a tool for hedging exchange rate
risk
3. As an instrument for speculation
4. As a portfolio asset
The focus of this paper is largely on
this last and most recent development
in FX thinking, which is opening up
opportunities for investors to integrate
currencies into their strategic asset
allocation framework.

Ironically, the largest financial market in the world is also one of the least understood.
In this paper, we attempt to demystify this important market by examining the basics
of currency investing and its impact on a traditional portfolio.

Currency as a portfolio asset

Analyzing the performance of currencies,
we find that adding FX exposure to
a traditional portfolio of stocks and
bonds can potentially enhance returns,
reduce volatility, and increase portfolio
diverfication. Significantly, we find that
currencies tend to be most effective
in a portfolio during periods of market
distress, when other assets are falling
in lock-step.

t is difficult to overstate the importance of foreign exchange for the world

economy. From the price of gas at the local pump to the cost of a vacation
abroad, changes in the foreign exchange (FX) market affect governments,
corporations, and individuals on a daily basis. Each day a staggering $4 trillion
in trades take place in currency markets around world; by comparison, U.S. stock
trading averages just $135 billion a day, and U.S. bonds about $1 trillion.1

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
Historically, currencies have performed two functions critical for society: serve as a unit
of account and act as a medium of exchange. And since money assumed different forms in
different places, there was always a parallel need for foreign exchange. For millennia, the
foreign exchange market has provided a forum for commercial activities between peoples.
Not much changed through the ages until the early 1970s, when the breakdown of the
Bretton Woods system of fixed exchange rates gave birth to the modern FX market.
For the first time, the price of currencies would be set according to the forces of supply
and demand. Exchange rate risk became an inescapable consequence of cross-border
commerce and investing. Currency suddenly had two new roles: as a tool for hedging
foreign exchange exposure and an instrument for speculation the most famous
example being the $1.2 billion in profits hedge fund manager George Soros netted
shorting the British pound in 1992.

Gaining exposure to currencies

Investors, today, can gain exposure to
currencies through a growing variety of
channels, direct or indirect, passive or
active. The most important ways are:
1. Investments in foreign stocks and
bonds
2. Currency derivatives
3. Currency baskets and strategic
indexes
5. Structured/market-linked products
6. ETFs/ETNs
7. Actively managed funds (mutual
funds, commodity trading advisors,
global macro and currency-specialist
hedge funds)

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.

May Lose Value

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.

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).

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 ones favor, but
over the long run the efficiencies of the market ensured
that gains and losses would wash out.

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.

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.

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
90006000 B.C.

500 B.C.

1800s-1930s

Post WWII1970s

1980s2000s

Present

UNIT OF ACCOUNT and MEDIUM OF EXCHANGE

PORTFOLIO HEDGING TOOL and SPECULATIVE INSTRUMENT
PORTFOLIO INVESTMENT
The concept of money arises.
Livestock and grains earliest
forms of currency.

Advent of modern coinage in

Imzir (modern-day Turkey) that
is portable and durable.

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 the gold-to-USD rate

is fixed, while all other major
currencies are pegged to the
USD. In 1971 U.S. abandons
ties to gold and floats currency,
ending system of fixed rates.

Speculative currency trading

grows. Evidence of persistent
returns among currency traders
attributed to manager alpha.

Wide acceptance of currency

as a stand-alone asset class,
recognition of alpha and beta
components to returns.

The concept of beta is akin to a rising tide raising all boats. It represents the market return.
Financial theory says returns on any portfolio can be decomposed into these two basic components, alpha () and beta (), and an error term, epsilon (), which denotes random
events or noise (which may sometimes be positive, sometimes negative). Statistical analyses can help differentiate whether a portfolios excess return over the market (beta) is the
result of true managerial skill, , or chance, .

2
3

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market, and foreign tourists, are examples of liquidityseekers. Significantly, the presence of these two distinct
groups means that a currency beta can, in fact, exist.
Of course, the above description ignores an important
component of the FX market: dealer banks that act as
intermediaries between the profit-seekers and liquidityseekers. These are usually large commercial and
investment banks that take the other side of transactions
initiated by either party. For providing liquidity to the
market, they receive a positive bid-ask spread.4 (Note,
our poker example still holds in this tri-party framework.
It is the equivalent of playing poker at a club, where the
house dealer takes a percentage of the winnings or
charges a fixed fee per hand.)
From theory to practice: Are profit-seekers profitable?
The idea of a two-tier market of profit-seekers and
liquidity-seekers is intuitive, but is it an accurate
description of the FX market in practice? Empirical studies
using futures data published by the Commodity Futures
Trading Commission (CFTC) indeed confirm that one
group systematically profits at the expense of the another.
The results of one such study by the Reserve Bank of
Australia are reproduced in Table 1.

Table 1: A
 verage weekly profits by trader type 1993-2003
(in US$ millions)*
Non-commercial/profitseekers
Gross Profit

Commercial hedgers/
liquidity-seekers

Net Profit**

Gross Profit

Australian Dollar

0.45

0.41

-0.72

British Pound

0.05

-0.21

-0.58

Canadian dollar

0.62

0.46

-0.63

Euro (1999-2004)

4.97

4.51

-7.71

German mark (pre-1999)

3.63

2.93

-5.71

Japanese yen

5.42

4.65

-8.62

Swiss franc

1.85

1.43

-3.52

Total

12.72

10.44

-20.84

Source: Kearns, J. and Manners, P. (2004). The Profitability of Speculators in Currency Futures
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
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.
**Assumes transaction costs of 0.03%.

If the structure of the currency markets provide systematic

returns to those willing to assume the risks, then one
question is what portion of the existing market consists of
profit-seekers? Figure 2, below, highlights the relative size
of the different segments of the FX market. Notice that
not only has the FX market nearly tripled in size over the
past decade, but it has undergone significant structural
changes as well. Today, profit-seekers, such as hedge
funds, are responsible for the majority of FX trading. Their
increased presence makes price discovery more efficient.
While thats good news for liquidity-seekers, it also means
shrinking premiums for profit-seekers.

Figure 2: D
 aily turnover in the FX market by source
(in $billions)
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%

$300

$500

$300
$1,900

$1,000
$1,500

1998

Banks

Investment Funds

2010

Corporates and Central Banks

Source: Bank of International Settlements (BIS), 2010

Common FX Styles: The hunt for beta

A feature of any asset class is that a significant portion
of their returns can be correlated to a set of distinct
investment styles or rules. In the case of equities, for
example, research shows that consistent returns are
possible by being systematically long small-cap stocks and
short large-cap stocks, buying value stocks and shorting
growth stocks, and purchasing recent winners and
shorting recent losers (momentum). That meant returns
that were formerly unexplainable (and considered alpha),
could be re-categorized as different forms of stock market
beta. The implications of these findings extend beyond
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
market makers, dealings banks have traditionally run separate proprietary trading desks that take directional bets on currency movements using the banks 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.

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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-thecounter (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
buyers 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

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. Exchangetrade 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 worlds premier
currency, and before that, it was the Dutch gilder.

Factors impacting currency markets

ABC requires pounds to

import goods from U.K.

Bank 1

Fund manager believes

the pound is overvalued.
Shorts GBP.

Hedge Fund

Bank 2

Source: Merril Lynch Investment and Guidance (IMG)

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.

Eichengreen, B. (2011, March 1). Why the dollars

reign is near an end. The Wall Street Journal
6
Osler, C. (2000). Support for Resistance: Technical
Analysis and Intraday Exchange Rates. FRBNY Review

$3,500

$3,324

$3,000
$2,500
$1,934

$2,000

$1,527

$1,500
$1,000

Hedges GBP exposure

by selling to Bank 1
@$1.4996
Buys GBP @$1.4995

$3,980

$4,000

$500

$1,499,500
1,000,000

Sells GBP @1.5000

to ABC Co.
Replaces GBP
inventory @$1.4996

$1,499,600

1,000,000

1,000,000

The rise of machines: the future of the FX

market

$4,500

Network of FX dealers
$1,500,000

In addition to the above fundamental factors, day-today 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

Chart 2: D
 aily turnover in the FX markets by instrument

in Billions

ABC Co.

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.

The two most important factors influencing currency

prices are interest rates and inflation. Countries with
higher interest tend to attract investors, increasing

Chart 1: I llustration of typical FX market transactions

demand for the local currency and causing it to rise

in value. Conversely, lower interest rates decrease
demand and depress value.

$0

$1,190
$590

1989

$1,239

$820

1992

Spot
transactions

1995

1998

Outright
forwards

2001

2004

2007

Foreign exchange
swaps

2010

Other

Source: BIS

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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 magazines Big Mac Index is a lighthearted but instructive application of PPP. The index
compares the price of McDonalds 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
(4.20/2.48). Since the actual exchange rate of
1.54 USD/GBP was lower than the implied PPP, it
suggested that the GBP was undervalued. According
to theory, the currency should appreciate until it
reaches the implied PPP.
We can make similar comparisons for other
currencies. The chart at right suggests the Swiss
franc is overvalued against the U.S. dollar, while the
Chinese renminbi is undervalued. Specifically, the
index estimates that, in dollar terms, a Big Mac costs
$6.81, or 60% more in Switzerland and just $2.44,
or 40% less in China. Under PPP, we would expect
the franc to depreciate and renminbi to appreciate

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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).

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 youre in Paris, London, or Dubai, step into
a McDonalds for lunch and to get a handle on the
FX market.

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 higherChart 3: L ocal currency over/under valuation against the USD, %*
yielding
1-year
euro deposits. They
6.81
Switzerland
5.68
Brazil
could negate the
4.94
Australia
exchange rate risk
4.73
Canada
and lock in the
0.00
U.S.
(4.16)
1% profit risk-free
Japan
(3.82)
Britain
by simultaneously
(3.54)
Turkey
selling a forward
(2.70)
Mexico
contract.
(2.57)
Egypt
Gap between
theor y and
practice
While theoretically
sound, as an
empirical matter
PPP and IRP

Russia
Indonesia
South Africa
China

(2.55)
(2.46)
(2.45)
(2.44)

-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60% 70%

Price in $
Source: The Economist (http://bigmacindex.org/2012-big-mac-index.html)
*Exchange rates as of January 12, 2012.

The carry trade is a medium- to long-term investment and

works best in low volatility environments. Thats because
traders are not only looking to buy currency pairs that
offer a positive carry but, equally, are seeking pairs where
that relationship is likely to hold or even improve. In the
AUD/JPY case, interest rates in Australia climbed to 7%
between 2003 and 2008, while essentially staying the same
in Japan. That growing difference in interest rates led to a
substantial appreciation of the AUD against the JPY and
significant capital gains for carry traders. However, the
trade broke down rapidly with the onset of the financial
crisis in late 2008, with the currency pair giving up five
years of gains in a matter of months, as shown in Figure 3.

AUD/JPY Exchange Rate

Figure 3: I llustrative example of an AUD/JPY trade

110
105
100
95
90
85
80
75
70
65
60
55
50
45

Capital Gain:
$23,500
Interest income: $25,208
Total Profit*:
$48,708

Sell AUD/JPY

Rush to unwind
the carry
Buy AUD/JPY

Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09

* 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.
Source: Bloomberg, IMG

Figure 4: E xample of an SMA trend-following strategy*

Most currency managers employ some form of trendfollowing or momentum strategy. Currencies often
exhibit trending behavior (i.e., display serial correlation)
that suggests past prices can be informative of future
movements. Rather than forecast where currencies are
headed, trend-following managers seek to ride existing
trends until they reverse.8 Managers often employ
technical indicators to detect trends. One basic technique
is the simple moving average (SMA). Applying a 50-day
SMA to the USD/JPY pair in Figure 4, an investor would
buy the pair anytime the exchange rate crossed its 50-day
moving average from below and sell it whenever price
crossed the same from above.
Trends can endure over a wide range of time periods,
appearing and disappearing in less than a day to lasting
for months. Furthermore, not all currency pairs trend (e.g.,
USD/CAD,USD/AUD, and EUR/CHF), and others may
do so only over certain periods. A key deficiency of trendfollowing models is that they are (by necessity) backwardlooking and work on the assumption that the near future
will be similar to the recent past, potentially exposing
managers to sharp market corrections and false trading
signals that add to costs.
Finally, volatility-based strategies are non-directional
strategies that seek to profit regardless of the direction
currencies take. Just as traders utilize derivatives to take
advantage of the equity markets implied volatility, traders
make use of equivalent measures in the FX market. One
counterpart to the well-known VIX index is Deutsche
Banks CVIX, which tracks the expected future volatility
in currency markets, and can be used to take directional
views on FX fluctuations. Volatility strategies typically

Figure 5: V olatility in the FX market

86

90
80

84

70
60

SELL signals (red)

VIX Index

USD/JPY

82
80
78

Buy
signals
(green)

76
74
Dec-10

Mar-11

Jun-11

USD/JPY
* Simple moving-average. Source: Bloomberg, IMG

Sep-11

Dec-11

Mar-12

50
40
30
20
10
0
Dec-01

Dec-03

50-day MA

Dec-05

VIX Index

Dec-07

Dec-09

25
23
21
19
17
15
13
11
9
7
5
Dec-11

DB CVIX Index

advantage of the difference in interest rates by going long

the AUD and shorting the JPY (the net interest earned or
carry would be added to the traders account at end of
each day the position was held).7

CVIX Index

Source: Bloomberg, IMG

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
7

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involve implementing an options straddle that entails

selling call or put options and collecting the premium when
managers expect currency movements to stay within a
narrow range or involves buying calls and puts to profit
from large swings in volatility.

H OW D O T H E F X S TR ATE G I E S PE R F O R M?
In a decade marked by the bursting of two asset bubbles
and increased volatility, the currency strategies described
above performed rather well. We used four Barclays
investable FX indexes the Barclays Intelligent Carry,
Barclays Adaptive FX Trend, Barclays FX Value, and
Barclays Tactical SBeta as respective proxies for these
styles, and examined their performance over the twelve
year-period from 2000-2011.9 Table 2 displays the results of
our analyses. The FX composite in the table is simply an
equalweighted average of these four strategies.
The first statistic that stands out is that currencies
clearly outperformed equities in our sample period, which
included both historic bull and bear markets. Moreover, the
discrepancy in performance between foreign exchange and
stocks was higher during bear markets. Second, we see
that foreign exchange, as measured by the composite, has
lower volatility than equities, giving rise to substantially
stronger risk-adjusted returns.

annual returns of 9.5% with a standard deviation of 6.1%

and maximum drawdown of 6.4% over the twelve years
covered. Next best were trend-following strategies with 6.1%
returns and 5.4% annualized volatility. Interestingly, the
popular carry strategy performed on par with the volatility
strategy until 2008. Its subsequent unraveling and weaker
performance is not all surprising given that the carry-trade
strategy works best in non-volatile markets. Trend-following
strategies, by comparison, do well in markets with clear
direction up or down, but suffer in choppy or sideways
markets.

T H E RO L E O F C U R R E N C I E S I N A
PORTFOLIO
While the potential for enhanced returns is certainly an
attractive proposition for investors, ultimately the most
important contribution of currencies may be their ability to
reduce portfolio volatility and drawdown.
Harry Markowitzs (1952) mean-variance framework
is a good starting point for any discussion of portfolio
allocation. The key lesson of Markowitzs seminal work was
that within a portfolio it is not essential what the risks of
the individual assets are, but rather what is crucial is the
extent to which the returns of those assets are correlated
with one another.
In that regard currencies can be particularly effective
portfolio diversifiers. From Table 3, we can clearly see
that currencies exhibit extremely low or even negative
correlation to most other asset classes.

Looking deeper, we find that within currencies, the

volatility-based FX strategies performed best posting

Table 2: F X Strategy Performance (20002011)

Carry

Trend

Value

Volatility

FX
Composite*

U.S.
Equities

Annual Returns

6.9%

6.1%

3.7%

9.5%

6.7%

1.0%

Volatility

6.1%

5.4%

5.9%

6.1%

3.3%

16.3%

0.77

0.71

0.27

1.15

1.28

0.01

-19.7%

-6.2%

-16.4%

-6.4%

-3.9%

-50.9%

Kurtosis

0.39

0.30

6.34

2.40

0.48

0.69

Skew

-0.29

0.03

1.13

0.47

-0.18

-0.45

14.8%

12.1%

10.5%

14.0%

13.0%

-4.2%

(6.0%)

(5.7%)

(4.9%)

(7.8%)

(3.3%)

(17.9%)

Sharpe Ratio
Max Drawdown

Returns (Volatility)
2000-2003

2004-2007

2008-2011

Table 3: F X correlations with major asset classes

(2000-2011)
Currencies

U.S.
U.S.
Bonds Credit

U.S. U.S. High Commodities

Equity
Yield

Currencies

1.00

U.S. Bonds

-0.06

1.00

U.S. Credit

-0.05

0.87

1.00

U.S. Equity

-0.04

-0.08

0.19

1.00

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

-2.1%

2.7%

-1.1%

5.1%

1.2%

-1.6%

(5.5%)

(5.1%)

(6.8%)

(5.9%)

(3.1%)

(20.6%)

Cash

0.25

0.07

-0.03

-0.06

-0.15

0.02

Source: Bloomberg, IMG. Carry, Trend, Value, and Volatility indexes represented by Barclays Intelligent
Carry USD, Barclays Adaptive FX Trend TR, Barclays FX Value Convergence, and Barclays Tactical
SBeta Indexes, respectively. *FX Composite based on the equal-weighted average of the four
strategies described above.
Past performance is no guarantee of future results.

Cash

1.00

Source: Bloomberg, IMG. Currencies, US Bonds, US Credit, US Equity, US High Yield, Commodities,
and Cash are represented by the FX Composite calculated in Table 2, BarCap US Aggregate Bond
Index, BarCap US Aggregate Credit Index, S&P 500 Index, BarCap US Corporate High Yield Index,
SP Goldman Sachs Commodities Index, and Citigroup 3 Month Treasury Bill Index, respectively.
Past performance is no guarantee of future results.

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

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Global Credit
Crisis

n12
Ja

n11
Ja

n10

n09

Currencies
Global HY (USD)

Ja

Ja

n08
Ja

n06

n07
Ja

Ja

n05
Ja

n03

n04
Ja

Ja

Ja

Ja

n02

1.00
0.80
0.60
0.40
0.20
0.00
-0.20
-0.40
-0.60
-0.80
-1.00
n01

12 Month Rolling Correlations

Figure 6: 1
 2-month rolling correlations of the S&P 500 with
other assets (2001-2011)

Commodities
Global Equities

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 assets 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

just with other assets, but also with each other. We found
that the average pair-wise correlation of the four currency
strategies was just 0.10 from 2000 through 2011.
An oasis of liquidity
Another characteristic of currencies that should be very
appealing to investors is the liquidity of the FX market.
During the last credit crisis, many financial markets
experienced significant disruptions and spikes in volatility.
While bid-ask spreads on major currency pairs did rise,
much of the FX market functioned relatively smoothly
during the crisis. In fact, according to the Bank of
International Settlements (BIS), many investors turned to
the FX market to hedge risks in other asset classes with
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 (20002011)
1%

2%

Average Monthly Returns

Average Monthly Returns

4%
0%
-2%
-4%
-6%
-8%

0%
-1%
-1%
-2%

-10%
-12%

-2%
Bottom 20%

Bottom 10%
Monthly U.S Stock Returns

FX Composite

S&P 500

Bottom 5%

Bottom 20%

Bottom 10%

Bottom 5%

Monthly U.S Bond Returns

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

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For our analysis we used an equal-weighted composite of

the four common FX styles described previously.
From Table 4, we can see that adding foreign exchange
enhanced returns and reduced portfolio volatility in all
cases. In addition, risk-adjusted returns rise progressively
higher with higher allocations to currencies. For example,
in the case of a $1 million portfolio, a 20% allocation to
currencies at the beginning of 2000 would have increased
total portfolio returns by approximately $125,000 by the
end of 2011.

Table 4: B
 enefits of adding FX to a traditional 60:40 portfolio
Traditional
Portfolio

10% FX
Allocation

15% FX
Allocation

20% FX
Allocation

U.S. Bonds

40%

36%

34%

32%

U.S. Large Cap Equities

60%

54%

51%

48%

Currencies

0%

10%

15%

20%

Annualized Return

3.5%

3.9%

4.0%

4.2%

Annualized Volatility

2.8%

2.5%

2.4%

2.2%

Max Drawdown

-33%

-29%

-28%

-26%

Return/unit of Volatility

1.27

1.55

1.71

1.89

Source: Bloomberg, IMG

For a more robust and forward-looking outlook on the

effects of incorporating currencies into a traditional
portfolio, we ran a 10-year Monte Carlo wealth simulation
(utilizing 10,000 iterations). The resulting probability
distributions confirm our previous empirical analysis.
Assuming the same $1 million initial investment, the
median terminal value for a traditional portfolio was
$1,464,000 for a portfolio with 10% FX allocation and
$1,408,000 for a 60:40 portfolio of stocks and bonds.
Moreover, the simulations provide us with better insight
into the ability of currencies to mitigate fat-tail events
or the risk of large-scale losses. For this purpose, we use
Conditional Value at Risk (CVaR) as our measure of risk,
calculated by averaging the worst 1% of losses from our
10,000 scenarios.11 We find that a 10% allocation to foreign
exchange can help reduce significant downside risk by 9%.
Our results suggest that there is potentially ample scope
for investors to improve their portfolios risk-return profile
by introducing a small amount of foreign exchange.

G A I N E X P O S U R E TO C U R R E N C I E S
Our analyses confirm many academic findings that
currencies can be an effective diversifying agent. The question
then is, how do investors actually allocate to foreign exchange?
In years past, there were few direct options. Foreign exchange
was the domain of institutional investors, where currency
pairs were traded in lots whose minimum investment size
was prohibitive to all but the biggest investors. Fortunately,
an important transformation in the FX market in recent years
has been its increased accessibility. Technological innovation
and product development now provide investors with a variety
of channels into foreign exchange.
Here, we list the basic ways investors can take on currency
exposure. A common but indirect way is through the
purchase of foreign securities. The returns on any foreign
stock or bond have two components that can be viewed
as assets within a portfolio: performance of the asset
itself and the change in exchange rate relative to the
home currency. How important is latter? Historically,
FX volatility has contributed more than 35% of the total
volatility of an international equity portfolio and more than
70% of the volatility of an international bond portfolio.12
To hedge or not to hedge?
To complicate matters, individual currencies can have
diverse and often complex relationships with local and
international financial markets. Certain currencies, such as
the U.S. dollar or Canadian dollar, are generally negatively
correlated with both local and global equity markets.
Others, such as the euro and yen, on the other hand tend
to be positively correlated (see Table 5). In general, when
correlations between these two components are negative
(positive), foreign investors realize a lower (higher) volatility
compared to their local counterparts in the same security.

Table 5: C
 orrelations of major currency pairs with world
equity markets
Dollar
Index

Euro

Japanese British Swiss Canadian Australian

Yen
Pound Franc Dollar
Dollar

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

Nikkei 225

-0.15 0.11

0.23

0.20

-0.01

-0.38

0.47

FTSE 100

-0.14 0.11

0.25

0.11

0.04

-0.46

0.49

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.
State Street Global Advisors industry estimates, 2009

11
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Naturally, the decision to hedge FX risk will depend on the

particular investors 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 tradeweighted 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).

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.

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.

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).

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

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
Potential Benefits

Potential Drawbacks

Foreign stocks

Mgmt Style
Passive

Liquidity
Dividends

Exposure to equity market risk

Stock-specific risk exposure

Foreign bonds

Passive

Liquidity
Income

Interest-rate risk
Credit risk of issuer

FX indexes (currency
baskets)

Passive

Efficiently express macro views on multiple countries or an entire

region
Simultaneous hedging of multiple currencies through options

No alpha generation
Interest-rate risk

FX structured products

Passive

Customizable
Accessible to most investors
May offer some principal protection

No alpha generation
Capped upside gains
Interest-rate risk

ETFs/ ETNs

Passive

Liquidity
Accessible to most investors

No alpha generation
ETNs subject to credit risk

Currency derivatives

Active

Liquidity
Leverage (up to 100:1)

Not accessible to all investors

Commodity Trading
Advisors (CTAs)

Active

Potential for alpha

Transparent

Not a pure play on currencies as mandate extends beyond FX

Poor liquidity and not accessible to all investors

Global macro funds

Active

Potential for alpha

Able to utilize wide array of instruments to execute trades

Mandate extends beyond FX

Illiquid and not accessible to all investors
Tax inefficient
Manager selection critical

Currency-specialist
hedge funds

Active

Deep expertise in currencies

Able to utilize wide array of instruments to execute trades

Less fund diversification

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

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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 currencybased exchange traded funds (ETFs). These vehicles trade
like equities and are designed to capture exchange rate
fluctuations. Depending on the investors objective, ETFs can
provide exposure to either a single currency or a basket of
currencies, with or without significant leverage. Exchangetraded 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 managers
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

Competently

managing portfolio risks, including the

use of leverage

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.

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.

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.

S O M E R I S K S TO C O N S I D E R

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.

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.

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11

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Bernard, L. S. (2011, July 9). Is Currency Trading Worth the Risk? The Wall Street
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Nadig, D. , Hougan, M. & Crigger, L. (2009). Currencies: The Overlooked Asset Class.
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Binny, J. (2005). Currency Management Style through the Ages. The Journal of
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Nasypbek, S. & Rehman, S. S. (2011). Explaining the returns of active currency

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Hafeez, B. (2007). Currency Indices in a Portfolio Context. Deutsche Bank.

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Power Parity. The Federal Reserve Bank of St. Louis Review.

Harris, L. (1993). The Winners and Losers of the Zero-Sum Game: The Origins of
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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

King, M. R., Osler C. & Rime, D. (2011). Foreign exchange market structure, players
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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
reviewed nor approved by BofA Merrill Lynch Global Research. The views and opinions expressed may differ from those of BofA Merrill Lynch Global Research or other departments
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information may not be current and GWIM IMG has no obligation to provide any updates or changes.
This document is being provided for educational and informational purposes only. Nothing herein is or should be construed as investment, legal or tax advice, a recommendation of any
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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its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy, completeness or timeliness of this document.
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 investments 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
funds. In addition to certain general risks identified below which are not exclusive, each product will be subject to its own specific risks, including strategy and market risk. Certain
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
income tax returns each year.
Currency Note: The currency market affords investors a substantial degree of leverage, which provides the potential for substantial profits or losses. Such transactions entail a high
degree of risk and are not suitable for all investors. Currency fluctuations may also affect the value of an investment.
Commodities: There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk,
economic changes, and the impact of adverse political or financial factors. Investing in commodities or the securities of companies operating in the commodities market involves a
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.
Investments may be highly illiquid and subject to high fees and expenses.
Derivatives: Derivative instruments may at times be illiquid, subject to wide swings in prices, difficult to value accurately and subject to default by the issuer. The risk of loss in trading
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
be volatile. Hedge funds have high fees and expenses that reduce returns. The characteristics discussed in this paper are typical attributes, as hedge funds and traditional funds
vary. Other key characteristics such as fees, minimum investments and liquidity should also be carefully considered. A hedge fund generally uses more aggressive strategies than a
traditional fund and entails a higher level or risk.
Managed Futures: Managed futures funds are speculative, involve a high degree of risk and are subject to substantial fees and expenses, which may offset trading profits. There can
be no assurance that any managed futures fund will achieve its objectives or avoid substantial or total losses. Since underlying positions held in managed futures funds may fluctuate
widely in value, individual funds can be highly volatile. Managed futures funds may also make significant use of leverage, adding to the volatility of a funds performance. Man-aged
futures funds may trade on unregulated markets lacking the regulatory protection of exchanges. Single-manager funds lack diversification and thus may involve higher risk. Since
many managed futures funds employ trend-following strategies, periods without clear trends in the market will typically be highly unfavorable to these funds. Managed futures funds
are subject to large drawdowns. The minimum margin requirements for various futures markets may subject investors to significant leverage. While margin-to equity levels are closely
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.

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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 markets 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.

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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

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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

212-449-3043

Global Head, Traditional Manager Due Diligence

201-557-0258

CIO, Multi-Asset Class Modeled Solutions

212-449-3385

CIO, PBIG and Ultra-High Net Worth Customized

Solutions
212-236-3159

Jim Russell,

Rick Galiardo,

Bill ONeill,

Victoria Ip,

CIO, Portfolio Construction and Multi-Manager

Solutions
201-557-0079

Global Head, Advice, Guidance and Research

Strategy
212-449-3348

CIO, EMEA
44-20-79955745

Chief Investment Strategist, Asia-Pacific Rim

852-3508-5305

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 Lynchs 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 Lynchs prior written consent.
2012 Bank of America Corporation. All rights reserved.
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