Exotic currency pairs

What the term covers 

An exotic pair sets one of the heavily dealt currencies, almost always the US dollar and occasionally the euro or the pound, against the currency of an emerging economy or of one whose exchange rate is administered rather than floated. The word is a description of turnover and of institutional depth. It says nothing about the size of the economy behind the currency, and several of the economies in this group are among the twenty largest in the world.

The group is conventionally read as several families rather than one list. The Latin American pairs, USD/MXN and USD/BRL, are dealt heavily during North American hours. The central and eastern European pairs, USD/PLN, USD/CZK, USD/HUF and USD/RON, trade against a euro area backdrop and are frequently read against the euro rather than the dollar. USD/TRY and USD/ZAR are the two most commonly cited high-volatility exotics. The Asian group, USD/INR, USD/THB and USD/PHP, contains currencies with varying degrees of convertibility restriction. And the Gulf group, USD/AED, USD/SAR, USD/QAR, USD/KWD and USD/BHD, behaves so differently from the rest that it is treated separately below.

Depth, and what its absence does to a price 

Fewer institutions quote an exotic pair, and those that do quote it in smaller size. The immediate consequence is a wider distance between the price at which the pair can be bought and the price at which it can be sold, and that distance is not a fee levied by anyone: it is the compensation a quoting institution requires for holding inventory in a currency it may not be able to offload quickly.

The second consequence is that the quoted spread understates the cost of dealing in size. A book with little depth is consumed quickly, so an order of a size that would fill at one price in a major reaches several levels down in an exotic and finishes at a worse average. The third is discontinuity. A market with few participants can move without trading at the prices in between, which is what gapping describes, and exotic pairs gap more often and by more than majors do.

The hours matter more here than anywhere else in the currency market. An exotic is quoted through the whole trading week, but the institutions with a genuine axe in it are concentrated in one region and one working day. Outside that window the price on the screen is real and the size behind it is minimal, and a domestic public holiday in the smaller economy removes most of the market's depth even though the pair continues to be quoted everywhere else.

Interest rate differentials and financing 

The policy rate of an emerging economy is frequently far above that of the United States or the euro area, because the central bank is managing higher domestic inflation, a weaker external position or both. That gap between the two policy rates is the interest rate differential, and in currency dealing it is not an abstraction: it is the largest input into the financing adjustment applied to a position held past the daily cut.

The adjustment has a sign, and the sign depends on which currency the position is effectively holding. Holding the higher-yielding currency conventionally produces a credit, and holding the lower-yielding one a debit. On an exotic pair, where the differential can be many percentage points a year rather than a fraction of one, the daily adjustment is a material line rather than a rounding item, and it accrues for every day the contract stays open.

The final row is why the differential is not read on its own. A convention known as the carry trade holds the higher-yielding currency against the lower-yielding one for the accrual, and the historical record of it is genuinely two-sided: the accrual is small and steady while the position is open, and the currency it is collected in is frequently the currency that repriced sharply against the holder when the conditions supporting the differential changed. Practitioners describe the pattern as a long sequence of small credits interrupted by a single large adverse move, and the differential itself carries no information about when that move arrives.

Policy and convertibility 

The single largest difference between an exotic and a major is how much of the exchange rate is determined administratively. Several of the economies in this group operate capital controls, restrict the conversion of their currency by non-residents, run a managed float within an undisclosed band, or intervene directly in the market to defend a level. A rate produced under those conditions is partly a policy variable, and it responds to a decision rather than only to a flow.

That is also why the tails are fatter. The historical record of emerging market currencies contains repeated instances of a rate held stable for an extended period and then repricing by tens of percent in days, when a band was abandoned, reserves ran short or a control was imposed or lifted. Nothing in the preceding period of stability signalled the size of the move, which is the honest description of the risk rather than a claim about any particular currency today.

The Gulf pairs are a separate case 

USD/AED, USD/SAR, USD/QAR and USD/BHD appear in exotic lists because of their turnover, but they behave in almost exactly the opposite way to the rest of the group. Each is held at a fixed rate against the US dollar by its monetary authority, and the fix has been maintained for decades. The observable result is a rate that barely moves: the quoted number sits within a narrow administered range and the ordinary drivers of an exchange rate, growth, inflation and the trade balance, do not express themselves through it.

The Kuwaiti dinar is the exception within the exception. It is managed against an undisclosed basket of currencies rather than against the dollar alone, so USD/KWD moves a little more than its neighbours, though far less than a floating currency.

Two consequences follow and both are structural. First, the peg transmits monetary policy: an economy holding its currency at a fixed rate against the dollar has to keep its own policy rate close to the US policy rate, or the fix comes under pressure, so Gulf rate decisions have historically followed the US decision closely. Second, the absence of movement in the rate does not mean an absence of exposure. It means the exposure sits in the arrangement itself rather than in the daily price.

How each Gulf regime is constructed, and what it does to the exposure carried by an account funded in a Gulf currency, is set out in the structure guides.