English Portfolio Management

FX fair value: Long-term entry level:

Based on the valuation of equities, but also currencies, the global macro investor will be able to build a diversified portfolio of ETFs.

Why consider currencies when investing in stocks?

We are all surprised by the one-off massive movements of reference currencies. It was striking, for example, to see the British pound so expensive at the turn of the century propelled by a strong British economy, only to collapse after the Brexit vote.

Sometimes these are shock consequences, such as the UK’s exit from the European Union, but there are many other anomalies in the markets. If you are investing separately in geographic markets (and not in a single global vehicle/fund), it may make sense to capture currency misalignments that should correct over time as fundamental values eventually reassert themselves.

These misalignments can produce gains for the investor in the long run but be careful not to adopt ruinous techniques such as forex or CFD speculation. Indeed, technical trading is difficult in the short term, and even more dangerous with leverage. Despite their volatility, currencies do not behave completely randomly over time with an equilibrium level, around which currency prices fluctuate in the short term. For a private investor, an investment based on an entry level in a currency should therefore be considered from a long-term fair value perspective only.

Predicting Long-Term Equilibrium: Theoretical Basis

The theory of efficient markets predicts that prices fully reflect all relevant information even though price movements may be disconnected from fundamentals at different times. Shiller, in his award speech for the Swedish Central Bank Prize (which is not a Nobel Prize!), thus argued that while financial returns are difficult to predict in the short run because of competitive trading, they are more reliable in the long run because there is more time for a reversion to the mean, i.e., to move out of extraordinary zones.

Alan Greenspan, former chairman of the U.S. Federal Reserve, noted that “after trying to forecast exchange rates for more than half a century, I have naturally developed a great deal of humility about my abilities in this area.” Exchange rates are complex to understand and evaluate because there is no simple, robust model that investors can rely on to assess the level and likely movements of exchange rates. Many amateurs less well prepared and less realistic than Alan Grenspan have already burned their fingers forecasting short-term exchange rates.

Most academic experts in the field however believe that there is a level to which a currency will gravitate in the long run. Fundamental forces should eventually bring the currency back to this relative level, despite significant short- and medium-term deviations. Thus, there are signals that the reader can use to better understand the long-run equilibrium value.

Factors Affecting Long-Term Currency Prices

Many models have looked at the determinants of exchange rates: some factors are interdependent and have opposite and opposing effects on rates, which makes it even more difficult to predict. The private investor will note that the following key determinants rarely hold in the short to medium term, but are good long-term guidance:

  • Inflation: Countries with high (low) expected inflation rates should see their currency depreciate (appreciate) over time (international parity conditions). According to the Fisher effect, the nominal interest rate differential between two currencies is equal to the difference between the expected inflation rates;
  • Currency interest rates: High interest rate currencies should depreciate relative to lower interest rate currencies, even if a rise in interest rates attracts foreign capital, which increases demand and strengthens the currency in the short run;
  • Competitiveness of countries: Countries with persistent current account deficits will generally see their currency weaken over time (balance of payments approach). Again, large imbalances may persist for a long time before triggering an exchange rate adjustment. Countries that introduce structural economic reforms that increase productivity will often see their currencies strengthen over time;
  • Tight monetary policy: Countries that implement relatively tight monetary policies will often see their currencies strengthen over time;
  • Fiscal policy: Countries that reduce their fiscal deficits will often see their currencies strengthen, but there will be contradictory effects: an expansionary fiscal policy usually leads to higher domestic interest rates and increased economic activity. Higher domestic interest rates generally lead to an inflow of capital, which is positive for the domestic currency in the short run, but the slowdown in economic activity also contributes to a deterioration of the trade balance, which is negative for the domestic currency (Mundell-Fleming model).

Basic PPP approaches

Investors typically rely on purchasing power parity by comparing the real effective exchange rate with purchasing power to assess anomalies. A simple strategy would be to compare the rates of currencies to their purchasing power (according to the theory of purchasing power parity – PPP). By measuring how many goods and services a currency can buy in each of the areas being compared, one can estimate over- and undervaluations.

This first approach is not as simple as it seems, as there are different calculation methods. It also suffers from a slow convergence speed. Many financial institutions and currency traders therefore seek to adjust the real effective exchange rates to obtain shorter half-lives and better convergence.

To express the speed of convergence, a commonly used measure is the half-life – the time it takes for deviations from the theoretical valuation to fall by half. Economists often cite PPP exchange rate half-lives of about 3 to 5 years, while one estimate by DBS Bank suggests that they can range from 19 months to 26 years (for the CNY). 

More sophisticated PPP approaches: Examples from JPM and DBS

For more accurate valuations, and faster convergence, more sophisticated professional investors such as J.P. Morgan and DBS have refined the PPP approach to determine a more robust indicator of currency fair value.

For best results, more forces influencing exchange rates must be considered. Various economic factors cause systematic deviations (or biases) in exchange rates from PPP, and these biases do not diminish over time. In addition to inflation differentials, evaluations must be supplemented by considering the impact of productivity differentials and terms of trade with trading partners.

The three main adjustments are therefore as follows:

1.    Relative PPP (including inflation)

  1. The starting point is the exchange rate that simply equalizes the price of goods between countries (absolute purchasing power parity defines an exchange rate between two currencies). Exchange rates, however, are related to price changes rather than price levels (relative PPP measures the change in PPP between two periods). Thus, countries with significantly higher inflation rates should experience nominal currency depreciation over time. Adjustments can be further refined by type of economy: For developed markets, J.P. Morgan applies a relative purchasing power parity (PPP), based on the long-term average of the real value of each currency for developed markets by adjusting today’s fair value for the expected inflation rate differential between the two countries. For emerging markets, J.P. Morgan uses an absolute approach based on PPP estimates for real individual consumption (with additional adjustment for the differential in GDP per capita growth).
  2. Productivity differentials: Empirically, we find that countries with higher GDP per capita generally have stronger currencies than PPP prescribes. Thus, real prices and real exchange rates should be systematically higher in countries with higher real productivity. The long-term decline in European productivity relative to that of the United States and China should be considered, for example. It is possible to use IMF data for real GDP per capita and terms of trade. However, this information is not readily available. Bond yields could be considered an important measure of market confidence and investor appetite. Even if such information is important for valuation and investments, we do not recommend to use it for any short-term forex speculation.
  3. Terms of trade: Imperfect substitutability of traded goods can lead to significant divergences in countries’ nominal terms of trade (i.e., the relative prices of exports versus imports). These divergences have an impact on equilibrium exchange rates through wealth effects.  For example, the booms in commodity prices were accompanied by the strength of the exporting countries’ currencies.

Other structural elements to be considered:

Beyond these adjustments, a context of generalized uncertainty, for example linked to the COVID-19 epidemic or the Ukrainian crisis, can also lead to particular situations: safe havens such as the USD and the CHF led to high valuations.

Conversely, seismic events in the market can also cause currencies to deviate excessively from their fair value. For the British pound, the Brexit and associated risks have made it difficult to return to fair value. Similarly, the extreme monetary measures in Japan have also removed the expected upward convergence for the yen.

Since no long-term strategy can anticipate a sudden sharp decline in terms of trade or a political jolt, positioning flexibility in response to unexpected market shocks is necessary.

A long-term currency approach for the private investor 

The global-macro private investor approach uses relative PPP with adjustments for major factors based on CFA Institute theory and DBS and JPM practice views.

Without doing all the calculations yourself, one can take solid sources of analysis on a quarterly basis. On this basis, we can classify currencies according to their valuations. The strategy then consists of favoring attractive equity markets based currencies whose valuation is below the relative median valuation (taking into account the valuation of the equity market and the entire portfolio). We can then focus on the currencies whose price is the lowest in relation to its fair value. According to DBS and JP Morgan for instance, the following situation can be considered:

Undervalued in (July 2022) 

– JPY (has depreciated to its lowest level since 1998)

– GBP (may have bottomed out, but is not ready to jump) 

– CAD to a lesser extent, as well as CNY (expected to be very slow to converge)


  • USD and CHF.
  • In Asia, currencies such as PHP, THB and INR considered expensive against the USD in August 2021 have weakened because of the Ukrainian crisis.

Practice for the private investor

This forex review, based on solid sources, could be done once a quarter to take advantage of solid data and not waste too much time analyzing currencies. It is useful for the private investor who is looking to gradually build a global portfolio based on distinct geographic constituents (see our recommended model for private investors) instead of a single international fund. The objective is still to own global equity assets, but to take advantage of undervaluation and non-speculative entry points to progressively build this diversified portfolio.

Remember that this approach is only one of many possible paths in the forex universe. In any case, the objective is not to speculate in currencies but to allow the selection of flagrant undervaluations linked with good entry points for diversified investments in markets not overrepresented in a portfolio.

The global macro investor will also be able to gather valuable information to build a portfolio of ETFs based on judicious forex entry points, while considering the level of equity valuations in these markets: For example, the Japanese market has seen its forex valuations fall while its stock market has held up better than others in the first half of 2022; unlike the UK where both equities and forex have fallen.

DBS, fx-strategy, 6.2022  
DBS, Group Research - Econs, Chang Wei Liang, 7.2021 and 5.2020  
DBS, Equilibrium Exchange Rates: Concept & Strategy, insights FX, 1.2020
JP Morgan Asset Management currency assumptions, 2020  
DBS, The DEER guide to long-term FX positioning,  
DBS Focus, 5.2020  
DBS, Currency fair values: What's cheap and what's DEER, 8.1.2020