Remember that time when the pound took a two-minute swan dive:
And no one really knew what caused it, except for suspicions of some kind of rogue algorithm getting over-excited?
Apparently, we now know some more about it:
I know I write about feedback loops quite often – but they’re clearly happening more often.
Here’s the thing though: flash crashes in the stock market are not ideal, but flash crashes in the forex market though!!!
- Most big listed companies will have lots of foreign currency risk in their business. Imports, exports, foreign dividend flows, etc.
- And because they’re big listed companies that can’t deal with that level of volatility in their margins, they hedge themselves against big movements in exchange rates.
- There are a few ways to hedge foreign currency risk, but almost all of them involve something that says “If the exchange rate moves against us, lock us in at a better rate.”
- At this point in time, I don’t think that anyone can really differentiate between the exchange rate moving because of bad news, and the exchange rate moving for two minutes because an algorithm went rogue at an awkward time and breached a level which kicked a whole army of algorithms into play with a bunch of stop-loss orders. I mean, you can differentiate after the fact – but when the rate starts moving, who the hell knows?
- So you can have a situation where a massive long-term hedging transaction gets kicked into high gear because of a bad mathematical equation, and a company like Sports Direct wakes up to discover that its risk-averse hedging strategy backfired and wiped out 5% of its annual profits.
So to summarise:
- Flash crashes in the stock market affect investments; but
- Flash crashes in the forex market affect operations.
I’d also add “flash crashes in the commodity market” to that second part of the list.
On the plus side – it’s a great time to be in a Treasury Department, because hedging has never been this multidimensional.
PS: that said, I think that there are better ways to hedge than stop-loss orders. Come on, guys. (Unless the infographic is wrong about their explanation, in which case, I take that back).
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.