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Just over three years after enacting a Minimum Exchange Rate policy for the Swiss Franc vs. Euro (EUR/CHF), the Swiss National Bank (SNB) removed it in a surprise announcement on January 15, 2015. The announcement shocked the FX market—EUR/CHF dropped 25.5 percent in the minutes that followed the press release. In our report FX Markets Move on Surprise News: Institutional Investor Trading Behavior around Brexit, the US Election, and the Swiss Franc Floor, we chronicled institutional investor trading behavior ahead of, during, and just after the SNB's announcement. We found evidence that (1) hedge funds predicated a trading strategy on the belief that the SNB would maintain the EUR/CHF floor, and (2) just after the policy was removed, hedge funds were on net large buyers of CHF, trading with the prevailing move in the exchange rate.
In this follow-up research, we examine hedge fund trading in EUR/CHF during the Minimum Exchange Rate policy period. In doing so, we found a pattern in hedge fund trading in EUR/CHF just before regularly scheduled SNB announcements that suggests that there would have been less buying of CHF and potentially less EUR/CHF exchange rate volatility on the policy removal announcement had the SNB removed the EUR/CHF floor at a regularly scheduled quarterly monetary policy meeting rather than via a surprise press release in between meetings.1
Specifically, to the extent that hedge funds bought EUR/CHF in between quarterly SNB announcements when the exchange rate was close to the 1.20 floor, we see evidence that they then sold EUR/CHF immediately ahead of the next regularly scheduled SNB meeting. Our results suggest that had the Minimum Exchange Rate policy been removed at a regularly scheduled SNB meeting, hedge funds would have been less long EUR/CHF just before the announcement, and therefore it would be reasonable to expect less overall buying of CHF and potentially less EUR/CHF exchange rate volatility just after the announcement.
The Swiss National Bank's Minimum Exchange Rate policy
The SNB implemented the Minimum Exchange Rate policy via a surprise announcement on September 6, 2011, noting that the “current massive overvaluation of the Swiss Franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development.” In order to weaken CHF in a sustainable and substantial manner, the SNB would “no longer tolerate” a EUR/CHF exchange rate below 1.20. To establish credibility for this policy, the SNB pledged to enforce it “with the utmost determination,” and to be “prepared to buy foreign currencies in unlimited quantities,” stating that “if the outlook and deflationary risks so require, the SNB will take further measures.”2,3
Over the ensuing months, the floor held—EUR/CHF settled between 1.201 and 1.261, as shown in the shaded region of Figure 1. Figure 1 also shows the increase in the SNB's foreign exchange reserves over the period that the floor was in place, which was likely a result of their intervention in FX markets: selling CHF and buying EUR (and other currencies) when CHF appreciated towards the 1.20 minimum. As a consequence, from the inception of the Minimum Exchange Rate policy in 2011 to the end of 2014, the SNB's balance sheet had grown from CHF318 billion to CHF542 billion (71 percent), and from 51 percent to 83 percent of Swiss GDP.4 Of the CHF542 billion total, 46 percent of the balance sheet was held in assets denominated in EUR.5 Assuming that the removal of the EUR/CHF floor would result in an immediate and sharp CHF appreciation, the increase in the SNB's FX reserves created a Hobson's choice—abandon the floor now and realize a large loss on the portfolio, or continue selling CHF and growing FX reserves and abandon the floor later, realizing even larger losses in the future.6
On January 15, 2015, the SNB surprised the FX market by entirely removing the EUR/CHF floor in an announcement in between two regularly scheduled meetings. The EUR/CHF exchange rate plunged from 1.201 to 0.895 (25.5 percent) over the next 24 minutes before partially retracing to settle at 1.053 (12.3 percent) at the end of the London trading day. To support their decision, the SNB suggested that the Swiss economy had been “able to take advantage” of the policy, and because of the recent weakness of CHF against USD, maintaining the Minimum Exchange Rate policy was no longer justified. The policy decision was accompanied by a 50 basis point cut in CHF three-month LIBOR, taking the interest rate further into negative territory (-1.25% to -0.25%).7
Figure 1: The EUR/CHF exchange rate and SNB FX reserves.
Hedge funds executed a trading strategy designed to profit if the Minimum Exchange Rate policy remained in place.
During the period in which the floor policy was in place, hedge funds predicated a trading strategy on the belief that the SNB would maintain the EUR/CHF floor. We will refer to this trading strategy as the long EUR/CHF strategy. The long EUR/CHF strategy worked as follows: If and when the EUR/CHF exchange rate approached the 1.20 floor, hedge funds would buy EUR and sell CHF in the anticipation that the exchange rate would rise (EUR would appreciate relative to CHF). As long as the SNB was committed to maintaining the EUR/CHF floor by purchasing an unlimited amount of EUR against CHF at 1.20, the potential loss on such a position was limited to the difference between the entry exchange rate and the 1.20 floor. However, if the SNB removed the EUR/CHF floor, CHF was likely to appreciate and the long EUR/CHF strategy would suffer severe losses in such a scenario. The upside of the long EUR/CHF strategy could be unlimited, depending on how EUR/CHF evolved. Thus, as long as the SNB's Minimum Exchange Rate policy remained in place, the risk/reward ratio of the long EUR/CHF strategy was compelling.
To illustrate the risk/reward ratio, suppose EUR/CHF were trading at 1.202. Buying EUR and selling CHF at 1.202 would have a maximum downside of 0.002 because in order to maintain the floor, the SNB would buy EUR and sell CHF somewhere between 1.202 and 1.20, not letting EUR/CHF drop below 1.20. If EUR/CHF were then expected to trade between 1.20 and 1.22 over the next three months, the maximum upside of the long EUR/CHF strategy would be 0.018, nine times the maximum downside.
The closer the EUR/CHF exchange rate was to the 1.20 floor, the more attractive the entry point for the long EUR/CHF strategy, because the 1.20 floor limited the downside of the long EUR/CHF position. The entry point for the long EUR/CHF strategy became less attractive as the EUR/CHF exchange rate moved away from the 1.20 floor because the downside increased. In the scenario above where EUR/CHF was expected to trade between 1.20 and 1.22, buying EUR/CHF at 1.215 would be a much less attractive entry point, because the downside (0.015) would be larger than the upside (0.005).
As noted in previous research, we saw evidence of hedge funds executing the long EUR/CHF strategy in our data. When the EUR/CHF floor was in place, hedge funds were more likely to buy EUR/CHF when the exchange rate was below 1.21. As indicated in Figure 2 below (reproduced from previous research), the sum of scaled net flows was more positive for exchange rate bins close to the 1.20 floor than for exchange rate bins further away from the floor (left panel); once the EUR/CHF floor was removed, there was no longer a relationship between hedge fund scaled net flows and the exchange rate (right panel).8
Figure 2: Hedge funds were more likely to buy EUR/CHF when the exchange rate approached the 1.20 floor (LHS). Once the floor was removed, this behavior ceased (RHS).
By executing the long EUR/CHF strategy, hedge funds were in effect helping the SNB support the Minimum Exchange Rate policy. The more these institutional investors bought EUR and sold CHF when the exchange rate approached the 1.20 floor, the less foreign exchange intervention the SNB would have to conduct and the less their foreign exchange reserves would grow.
Two additional considerations are important to note when considering the implications of this trading strategy relative to the European Central Bank's (ECB) and SNB's policy decisions and the consequences of the SNB's decision to remove the EUR/CHF floor via a surprise press release. First, the interest rate differential between the EUR deposit rate and the CHF deposit rate also impacted the attractiveness of the long EUR/CHF strategy: Higher EUR deposit rates or lower CHF deposit rates led to better “carry” for an investor with a long EUR / short CHF position and thus higher profits.9 Therefore, the interest rate decisions from the SNB and the ECB during the floor period may have affected the incentives to enter this trading strategy.
Second, hedge funds likely used leverage to increase their potential returns from the long EUR/CHF strategy. The typical market maker or prime broker would require a hedge fund to post an independent amount (or collateral) of around 10 percent against such a transaction, which implies the hedge fund could achieve leverage of 10 times. While leverage enhances returns, it also inflates losses relative to the amount of equity capital supporting a position. Therefore, investors that employ leverage are less able to withstand large losses and may be forced to exit loss-making positions earlier than investors that do not employ leverage. For example, a hedge fund using 10 times leverage to establish a position that then suffers a 10 percent loss would have their equity reduced to zero and would likely be forced to liquidate the position. As we will discuss later, the use of leverage may explain the extent to which hedge funds bought CHF after the SNB's surprise announcement.
Hedge funds bought a large quantity of CHF in the minutes after the Minimum Exchange Rate policy was removed, trading with the prevailing move in the exchange rate.
As noted in previous research, the net flows during the 24 minutes following the surprise announcement from the SNB indicated that net risk transferred was largely one way—all investor sectors were either buying CHF or absent. Figure 3 shows scaled net flows for hedge funds on January 15, 2015, aggregated into three-minute periods. In the first three minutes after the announcement, hedge funds bought large quantities of CHF (sold EUR/CHF), trading in a manner consistent with the appreciation of CHF. Because hedge funds (and other institutional investors) were on net buying CHF as it appreciated, market makers were left as the only market participants selling CHF during this critical stage. While we don't measure the connection directly, the hedge fund buying just after the press release may have amplified the initial move in the exchange rate—between the 9:30 a.m. announcement and 9:54 a.m., EUR/CHF dropped from 1.201 to 0.895, before recovering to settle around 1.053 at the end of the London trading day.
We hypothesize that the long EUR/CHF strategy described above could partially explain why hedge funds were buying large quantities of CHF in the three minutes after the policy was removed. The immediate and sharp appreciation of CHF just after 9:30 a.m. created losses for any investor left holding the long EUR/CHF strategy. Hedge funds losses were likely amplified due to the use of leverage. Hedge funds continued to purchase CHF over the rest of the day, and by the close of business in London, their CHF purchases outpaced sales by nearly six to one.
Figure 3: Hedge funds purchased large quantities of CHF in the first three minutes after the SNB announced the removal of the EUR/CHF floor.
To conduct financial markets research, the JPMorgan Chase Institute uses a unique, de-identified trade-level data asset that includes all available institutional investor transactions where the Markets Division of J.P. Morgan's Corporate & Investment Bank (CIB) acted as the market maker. The data set includes 395 million de-identified transactions across 44,000 institutional investors and covers all types of institutional investors, all regions globally, all asset classes (foreign exchange, equities, fixed income, and commodities), electronic and voice trades, and the post-financial crises period (historical coverage varies by asset class).
For this report, we used a sample of transactions where the following criteria were met:
FX spot or forward trades in EUR/CHF
Institutional investor is a hedge fund
Executed while the SNB's Minimum Exchange Rate policy was in effect
Eliminated trades with: missing trade date/execution time, zero/missing buy or sell amount, and missing investor sector
Our final analysis sample includes 35,000 trades from 120 hedge funds.
The CIB's market share in foreign exchange varies from year to year between 10 percent and 15 percent. Broadly speaking, we believe that the CIB's overall market share is large enough that our data is representative of the market activity of all hedge funds in the market we studied. However, there is natural variation in the CIB's market share across different currencies, investor sectors, regions, and time zones, and this is an important factor to consider when interpreting the results of our analysis.