More Thoughts on Deciding What to do with the Brazil Real

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Investors continue to grapple with the best way to work around Brazil's new 2% front-end tax on foreign inflows. Understanding that in order to minimize impact, many investors would contemplate holding BRL balances received as proceeds of a sale, a dividend or coupon payment to use to make purchases of other Brazilian assets at some future time, we looked at the volatility of the BRL-USD exchange rate. The implied volatility and the actual weekly range of the BRL suggests that the risk of holding the BRL balances is that the currency movement can in a relatively short period be larger than the 2% tax.

This in turn leads to a follow-up question. Is there a guide or tool one can use to help identify the direction of the Brazilian real ? What would be useful is some way to identify the underlying trend in the BRL so that when it is strengthening, one might decide to let the BRL balances build and when the BRL is weakening, one might decide to convert the BRL.

Often moving averages are seen as one type of technical tool that is useful in identifying trends. Of course the preference is for a simple straight forward rule. For example, derive a rule that if the dollar is above its 20 day moving average against the BRL, the BRL proceeds are converted on ideas the BRL is in a downtrend. If the dollar is below its 20 day moving average against BRL, the proceeds are maintained on ideas that the BRL is in an appreciating mode. This is among the simplest approaches. However, there are occasions this year where the dollar rose 5% above its 20-day moving average against BRL.

Another slightly more complicated strategy would entail using two moving averages, a short and long, and using the cross over to decide what to do with the BRL. When the shorter term moving average for the dollar is above the longer term, one would convert the BRL proceeds and allow the BRL balances to build if the shorter term average is below the longer term average.

The trade off here is sensitivity of the moving averages to price swings, how many cross over signals are generated and how many good and false signals. The shorter the moving average terms are, the more sensitive the moving average is to prices and the more signals are generated.

There are numerous computer programs that optimize moving average cross over signals. While they can be helpful, the problem is that one optimizes the moving averages for some past period (in sample test) and then applied to the present and future (out of sample) when those moving averages may not longer be optimal perhaps due to a change in the volatility of the market.

For the record the 20-day moving average of the dollar comes in near BRL1.7375, which is around where it is currently trading. The 5 day moving average is just above BRL1.73.

This note is not meant to propose a particular set of decision making rules, but rather to suggest ways that investors may want to think about whether to convert the BRL proceeds or not, given the new 2% tax.