# Using Generalized Forecasts for Online Currency Conversion

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1 Using Generalized Forecasts for Online Currency Conversion Kazuo Iwama and Kouki Yonezawa School of Informatics Kyoto University Kyoto , Japan Abstract. El-Yaniv et al. presented an optimal on-line algorithm for the unidirectional currency conversion problem based on the threat-based strategy. Later, al-binali pointed out that this algorithm, while certainly optimal in terms of the competitive ratio, may be too conservative from gamblers view points. He proposed the trading strategy using the forecast that the rate will increase to at least some level M 1. If the forecast is true, the algorithm achieves a better competitive ratio than the ratio r0 of the threat-based strategy. Otherwise, the algorithm suffers from a loss a worse ratio than r0 but it can be controlled within a certain factor. In this paper, we generalize this notion of forecasts: i Not only the forecast that the rate will increase to some level, called an above-forecast, but the forecast that the rate will never increase to some level, a belowforecast, is also allowed. ii Forecasts are allowed twice or more. Several different algorithms can be designed using this extension, e.g., an algorithm making two rounds of forecasts where one can regain r0 by the second forecast even if the first forecast is known to be false. Furthermore, we discuss the bidirectional conversion i.e., both conversions from dollar to yen and yen to dollar are allowed which helps even for a monotonically-changing rate, if below-forecasts are involved. 1 Introduction As far as their performance is measured by the worst-case competitive ratio, it is not surprising that on-line algorithms tend to be conservative or tend to be risk-avoiding. A typical example is the threat-based algorithm, by El-Yaniv et al., for the unidirectional currency conversion problem UCCP [EFKT92]. Although it achieves the optimal competitive ratio, denoted by r 0 throughout this paper, it does not reflect common practice of traders. For example, investors usually make some assumptions about the future [CCEKL95] and also are willing to take risk while trading [RS70,RS71,SSW95,Mor96], but it is hard to evaluate those actions within the framework of the conventional competitive ratio. In his recent paper [alb97], al-binali proposed competitive analysis which allows a trader to make a forecast. If the forecast is true, then the trader can get a better ratio than r 0; otherwise the trader suffers from a worse ratio than r 0. The important point is, however, that the risk can be controlled within the factor of t, say, t = Namely the worse ratio is guaranteed not to be worse than tr 0. In [alb97], al-binali mainly discusses UCCP and gives the following algorithm: i The algorithm takes, as a part of parameters, a forecast given by a rate M 1 and the risk-tolerance factor t > 1. The forecast means that the rate will increase to at least M 1. ii If the forecast is true then the algorithm achieves the competitive ratio r 1 < r 0 that is determined by t and is optimal under the following condition: iii If the forecast is not true, the ratio of the algorithm is not worse than tr 0. Namely, one can take a risk which is controlled within a certain factor and can get an optimal reward from the risk.

2 In this paper, we generalize this risk-taking strategy for UCCP in two respects: 1 A forecast in [alb97] is limited to the type that the rate will increase to some level. We also allow the opposite type, i.e., the forecast that the rate will never increase to some level. Forecasts of the former type are called aboveforecasts and the latter below-forecasts. 2 In the course of trading, forecasts can be made twice or more. By these extensions, it is now possible to take several different types of flexible strategies, for example, the one such that the player makes an above-forecast first and then, if it is successful, he/she makes a second forecast, say, a below-forecast, to aim at an even better competitive ratio. Another example is the double-below-forecast strategy where even if the first below-forecast fails, i.e., if the rate has increased to the level of the first forecast, one can regain r 0 if the second below-forecast is successful. To assist designing these variety types of algorithms, we provide a scheme which enables a systematic generation of on-line algorithms for UCCP including several forecasts. For this purpose we need a new necessary and sufficient condition for being able to design optimal on-line conversion algorithms, not for the entire trading period but for its partial period. Another new finding in this paper is the usefulness of the bidirectional conversion. It should be noted that under the condition of unidirectional conversion, we can assume that the exchange rate is monotonically increasing and finally drops suddenly without loss of generality. In other words, one can see easily that the unidirectional conversion is enough for the threat-based strategy. Also, it is not hard to prove that the unidirectional conversion is enough even if aboveforecasts are introduced. However, the situation does differ for below-forecasts: It is shown that the bidirectional conversion enables us to design an algorithm whose competitive ratio for successful forecasts is much better than we can do using only unidirectional conversion. 2 Threat-Based Strategy In the unidirectional currency conversion problem UCCP, an on-line player converts dollars to yen over some period of time and must convert all the remaining dollars at the end of a trading period. It is prohibited to convert already purchased yen back to dollars, i.e., the trade is unidirectional. Under this setting, we can assume, without loss of generality [EFKT92], that the exchange rate starts from e 0, increases monotonically up to some rate e max, drops suddenly to e fin and stay there forever see Fig. 1. M and m denote the upper and lower bounds, respectively, of the exchange rate. The player initially holds one dollar and wishes to get as much yen as possible at the end of the game. The performance of on-line algorithms is measured by the competitive ratio: Suppose that the player carries out trading using some algorithm, A, which determines the trades. Dx and Y x denote such amounts of dollars and yen, respectively, when the rate is x. Thus the player obtains Y e max +e fin De max yen at the end of the game. The off-line player can get e max yen by changing the original one dollar at the highest rate and hence the competitive ratio of the algorithm A is the worst-case value of e max /Y e max + e fin De max. The threat-based strategy [EFKT92] requires the on-line player to make the following action: To attain a given competitive ratio r 0, the player should simply defend himself/herself against the threat that the exchange rate may drop to its minimum value m at the next moment. More concretely, i the player does not trade at all when x r 0 m. ii The player carries out the trading so that his/her Dx and Y x will always satisfy that mdx + Y x = x/r 0 when x > r 0 m. As a result, Dx and Y x can be given as

3 Dx = 1 1 ln r 0 r 0 m m, 1 Y x = 1 m ln r 0 r 0 m m + x r 0m. 2 It is not hard to see that the optimal r 0, denoted by r0, must satisfy that DM = 0, which implies that r0 = ln M m r0 3 m m. This is the case for e 0 r 0 m. If e 0 > r 0 m, formulas 1-3 change a little as follows: Dx = e 0 e 0 /r 0 e 0 m 1 ln r 0 e 0 m, 4 Y x = e 0e 0 r 0 m + 1 m ln r 0 e 0 m r 0 e 0 m + x e 0, 5 r0 = 1 + e 0 m ln M m e 0 e 0 m. 6 The value of r0 in 6 is now a function of e 0 and is different from r0 in 3. Unless otherwise stated, however, r0 always means the value of 3 in this paper. The model so far described is called the continuous model, where the player can trade at any moment. The other model is the discrete model, where the player can trade only at discrete time steps. In this paper, we restrict ourselves to the continuous model but similar results also hold for the discrete model. 3 Designing Multi-Phase Conversion 3.1 An Useful Property Suppose that the player has the above-forecast M 1, i.e., the forecast that the rate will increase up to at least M 1 m < M 1 < M. Then, during the period when the rate x is between m and M 1, the player exchanges less dollars to yen compared to the threat-based algorithm. This allows the player to hold more dollars when the rate reaches M 1 i.e., if the forecast is successful. After that, the player can exchange more dollars, which gives him/her a better competitive ratio than that of threat-based. Thus, trading based on forecasts consists of two or more phases of different trading strategies which should be combined at the moments when the rate has reached the value of the forecast. In this section, we first give a useful property when designing each single phase. Also we shall see how to use that property to design a whole multi-phase conversion algorithm using a simple example, i.e., a conversion algorithm which involves a single above-forecast. More sophisticated algorithms will be designed in the next section. An interval is denoted by a pair [N 1, N 2 ], m N 1 < N 2 M, of exchange rates. Suppose that we fix some conversion algorithm, A, that works for this interval. Then A determines DN 1 and Y N 1, the amounts of dollars and yen at the beginning of the interval, DN 2 and Y N 2, the amounts of them at the end of the interval if the rate reaches there, and the competitive ratio r. Conversely speaking, it would be possible to design A from such values as DN 1, Y N 1, DN 2, Y N 2, and r. Actually those five parameters are not independent, so that we only need some of them. For example, the threat-based algorithm is a unique algorithm, A, which satisfies i Drm = 1, Y rm = 0 and DM = 0, and ii A is optimal in the sense that A achieves the same

4 competitive ratio, r, whenever the rate drops to m between rm and M. The remaining values, Y M and r, are determined automatically. Here is a little more general statement for an optimal algorithm to be designed: Theorem 1. Suppose that an algorithm, A, satisfies that DN 1 = d 1, Y N 1 = y 1 and a competitive ratio r is given. Then an optimal A, by which the player can achieve the competitive ratio r and he/she can continue trading as far as possible, is uniquely determined. Proof. Observing the argument of the threat-based algorithm in [EFKT92], it is not hard to see that an optimal conversion algorithm can be designed by the following basic policy: i The competitive ratio during the trading should not be greater than r, whenever the rate drops to the minimum rate m. ii If the current amounts of dollars d and yen y satisfy that md + y x/r for the current rate x and the target ratio r, then one should not trade now. By this one can keep more dollars to exchange at higher rate. Just recall the threat-based algorithm: Policy ii applies while x r 0 m, and after that the trade proceeds based on policy i. Now we apply these policies to the present situation. 1 If N 1 rm then policy ii applies. One should not trade until the rate reaches rm, because if N 1 rm, one should have 1 dollar and no yen. After the rate reaches rm, the trade can be governed by the following formulas which are exactly the same as 1 and 2 except that r 0 is replaced by r. Dx = 1 1 r ln rm m, 7 Y x = 1 m ln r rm m + x rm. 8 Note that trade can continue until the moment x such that Dx = 0. 2 If N 1 > rm, then we have furthermore two cases: Case 2-1 md 1 + y 1 N 1 /r. In this case, we have to exchange some amount of dollars to yen at the beginning, since otherwise we cannot achieve the ratio r if the rate drops now. The amount of dollars that we have to trade at this moment is determined so that the amounts of the dollars d 1 and yen y 1 after the exchange will satisfy that md 1 + y 1 = N 1 /r. And it must be satisfied that m d 1 d 1 = y 1 y 1. N1 d 1 + y 1 N1 r From these formulas, it turns out that d 1 1 = N 1 m 1 N 2 1 N 1 m r mn 1d 1 + y 1. After that, the trade proceeds by, y 1 = Dx = d 1 1 r ln N 1 m, 9 Y x = y m ln r N 1 m + x N Case 2-2 md 1 + y 1 > N 1 /r. In this case the policy ii applies. We have to wait until the rate goes up to Ñ1 > N 1 such that md 1 + y 1 = Ñ1/r, because otherwise we cannot gain a certain ratio during [N 1, N 2 ]. After that we should follow the following formulas: Dx = d 1 1 r ln Ñ 1 m, 11 Y x = y r m ln Ñ 1 m + x Ñ1. 12

5 3.2 Single Above-Forecast Let us design an optimal algorithm, A, using a single above-forecast M 1 : Namely, if the rate drops before the rate reaches M 1 then A may achieve t > 1. Note that M 1 m must be satisfied for such a trade to be possible. Under this condition, we wish to design A so that we can achieve the optimal competitive ratio after the rate gets to M 1. We assume that the starting rate e 0 is less than rm. The other case is similar and omitted. This is the same also in the rest of the paper. 1 While the rate is between [e 0, M 1 ], we design the optimal algorithm of the competitive ratio by the case 1 of Theorem 1. Let D 1 x and Y 1 x be the amount of dollars and yen the player should hold. Then D 1 x = 1 1 ln 13 m m, Y 1 x = 1 m ln m m + x tr 0m. 14 Now we can calculate D 1 M 1 and Y 1 M 1. 2 For the interval [M 1, M], we once assume a tentative competitive ratio r 1 which must be better than r0 and design the optimal algorithm from D 1 M 1, Y 1 M 1 and r 1, by using Case 2-1 of Theorem 1. Let D 2 x and Y 2 x be the amounts of dollars and yen in this phase. Then D 2 x = d 1 ln r 1, 15 Y 2 x = y + 1 m ln r 1 + x M As mentioned in the proof of Theorem 1, a certain amounts of dollars are sold at this moment to get d dollars and y yen, which must satisfy 1 1 ln m m M 1 1 r 1 1 tr 0 1 r 1 ln M m = By solving these equations, we can obtain d and y as d = D 1 M 1 M1 1 M 1 m r 1 1 tr 0 and y = Y 1 M 1 + M M 1 m r 1 1 tr. Then by substituting them into 15 and 0 16, one can get D 2 x and Y 2 x without d or y. Now the optimal value for r 1 should satisfy that D 2 M = 0, or 1 1 ln m m M 1 By solving this equation, one can get r 1 = 1 1 tr 0 ln M1 m tr 0m m + M1 tr r 1 1 ln M m = r 1 M1 + ln M m. 19 When m = 100, M = 200 and t = 1.01, the relation between r 1 and M 1 is expressed as in Fig. 2. Note that r in this setting. Thus, the value of r 1 decreases is getting better almost in linear as M 1 grows. In other words, if the player takes more risk selects higher M 1 then he/she can get linearly more benefit if the forecast is true. It should be noted that in [alb97], al-binali did the similar argument for the discrete model.

6 4 Several Multi-phase Algorithms 4.1 Double Above-Forecasts The player uses two above-forecasts M 1 and M 2 m < M 1 < M 2 < M aiming at a furthermore better competitive ratio after the first above-forecast succeeds. If the first forecast fails, then the competitive ratio is. If the second forecast fails, it is r 1. Finally, the ratio is r 2 if the second forecast is true. The design procedure is exactly the same as before, i.e., one can design the optimal algorithm from the first phase [m, M 1 ], then [M 1, M 2 ] and finally [M 2, M] sequentially. This gives us r 2 as a function of r 1. If we assume that r 1 = tr1, 1 where r1 1 is the optimal value of r 1 in the case of a single above-forecast discussed in Section 3.2, then the optimal value of r 2 i.e., by which the value of dollars becomes zero at M can be given as follows: r 2 = 1 1 tr ln M1 m 0 m m M 2 M 2 m M1 M 1 m + ln M m 1 r 1 1 M 2 m 1 r 1 ln M2 m M 1 m + M 2 r 1M 2 m. 20 For example, when M 1 = 150 and M 2 = 175, the values of r 1 = tr 1 1 and r 2 are about and 1.266, respectively. Recall that r if the player uses only a single above-forecast at M 1 = Single Below-Forecast The player can get a better ratio r 1 < r0 if the rate drops before M 1. Otherwise the ratio may be as worse as. 1 For interval [m, M 1 ], we apply case 1 of Theorem 1, by using r 1 as the competitive ratio in this interval. For r 1 m x M 1, D 1 x and Y 1 x are given as D 1 x = 1 1 ln r 1 Y 1 x = 1 r 1 m ln r 1 m m, 21 r 1 m m + x r 1m 22 and we can get D 1 M 1 and Y 1 M 1. 2 Now we design the second phase using the values of D 1 M 1, Y 1 M 1 and. Since r 1 < r0 <, it follows that md 1 M 1 + Y 1 M 1 > M 1 /, which means we should apply Case 2-2 of Theorem 1. Let M 1 be the rate such that md 1 M 1 + Y 1 M 1 = M 1 /. Then D 2 x and Y 2 x are given as follows: D 2 x = D 1 M 1 1 ln tr 0 Y 2 x = Y 1 M tr 0, 23 m ln + x M Note that the value of M 1 must be selected such that M 1 r1 tr M, since M 0 1 should be at most M. The optimal value r1 for r 1 is obtained by setting D 2 M = 0, or as the solution of equation 1 1 ln r 1 r 1 m m 1 ln M m = 0, 25

7 where M 1 takes the value given above. Let us set t = 1.01 again and recall that r Then r 1 is a function of M 1 as shown in Fig. 3. The value of r 1 increases becomes worse linearly as M 1 grows, namely, the merit when the forecast succeeds becomes smaller as M 1 grows. This is reasonable since as M 1 grows the forecast is more likely to be successful. However, this growth of r 1 is saturated after M 1 = 140. Therefore, it might not be a good idea to select M 1 = 140, since the risk-reward is very similar to the selection that, say, M 1 = 170. M 1 = 170 is much easier for the success of the forecast. 4.3 Double Below-Forecasts In the case of above-forecasts, when the player knows that his/her forecast fails, the game is over. Conversely, in the case of below-forecasts, the game still continues after the forecast is known to be false, but of course the guaranteed competitive ratio goes down under r0. Therefore, it is a natural idea for the player to try to regain r0 after he/she knows that the below-forecast M 1 has failed, by making another below-forecast M 2. 1 We assume that the first phase [m, M 1 ] is exactly the same as the first phase of the single below-forecast. D 1 M 1 and Y 1 M 1 are obtained as before. 2 The competitive ratio for second phase [M 1, M 2 ] is r0. Use Case 2-2 of Theorem 1. D 2 x = D 1 M 1 1 r0 ln, 26 where M 1 = r 0 M The third phase guarantees the competitive ratio r 2. It then follows that D 3 x = D 2 M 2 1 ln r 2 M 2 m, 28 where M 2 = r 2 M 2. r 0 29 The optimal r 2, r2, is obtained when D 3 M = 0, namely as the solution of the following equation 1 1 r1 This implies that r 1 ln r1 m m 1 r0 ln M 2 m 1 ln M m = r 2 M 2 m r 2 = 1 1 r 1 ln M m M 2 m ln M1 m r 1 m m 1 r 0 ln M2 m. 31 M 1 m When M 1 = 120, the relation between r 2 and M 2 is illustrated in Fig. 4. For example, when M 2 = 160, The competitive ratio for each phase is 1.17 for the first phase see Fig. 3, 1.28 =r 0 for the second phase and 1.30 for the third phase. The difference between the second and the third phases is small since t is close to 1. Actually, the competitive ratio for the single below-forecast is 1.18 and 1.29 for the first and second phases, respectively. Thus the double below-forecast is not so interesting in this setting. If we set t = 1.05, then the above values change to 1.13, 1.28 and 1.38 for the three phases. In the case of a single below-forecast, the values are 1.13, 1.34 and 1.34 the second and the third phases are the same. Thus the difference becomes much clearer.

9 2 For the second interval [M 1, M], we apply Theorem 2. At rate M 1, we buy some dollars back so as to have d dollars and y yen that should satisfy md + y = M 1, 34 d D 1 M 1 = 1 M 1 Y 1 M 1 y. 35 Now the trade in the second phase is expressed by D 2 x = d 1 ln, 36 Y 2 x = y + 1 m ln + x M Note that D 1 M 1 0 must be met, which restricts the selection of M 1. The optimal value r1 for r 1 is obtained by setting D 2 M = 0, which is the solution of the next equation: 1 1 ln r 1 r 1 m m + M r 1 1 ln M m = When t = 1.01, the value of r1 is illustrated as the solid line in Fig. 5. It should be noted that it is much better than the value of r1 obtained in Section 4.2 see the dotted line in Fig. 5. Multiple below-forecasts can be designed similarly. 6 Concluding Remarks In this paper, it is assumed that a forecast is just successful or not. In practice, however, people usually think a specific forecast will come true with a certain probability p. Hence, the merit one can enjoy when the forecast succeeds is to be given as a function of p. Although the probability distribution is hard to guess, this is obviously one possible extension of this work. Another possible extension is to introduce forecasts in the real bidirectional-conversion game where the rate can change up and down [DS97,EFKT92]. References [alb97] Sabah al-binali. The Competitive Analysis of Risk Taking with Applications to Online Trading, Proc. 38th IEEE Symposium on Foundations of Computer Science FOCS, pp , [CCEKL95] A. Chou, J. Cooperstock, R. El-Yaniv, M. Klugerman, and F. T. Leighton. The statistical adversary allows optimal money-making trading strategies, Proc. 6th ACM-SIAM Symposium on Discrete Algorithms SODA, pp , [DS97] E. Dannoura and K. Sakurai. On-line versus off-line in money-making strategies with brokerage, In Eighth Annual International Symposium on Algorithms and Computation ISAAC, [EFKT92] R. El-Yaniv, A. Fiat, R. Karp, and G. Turpin. Competitive Analysis of Financial Games, Proc. 33th IEEE Symposium on Foundations of Computer Science FOCS, pp , [Mor96] J. P. Morgan. RiskMetrics T M Technical Document, fourth edition, [RS70] M. Rothschild and J. E. Stiglitz. Increasing risk I: A definition, Journal of Economic Theory, 2: , [RS71] M. Rothschild and J. E. Stiglitz. Increasing risk II: Its economic consequences, Journal of Economic Theory, 3:66-84, [SSW95] C. W. Smithson and C. W. Smith Jr., and D. S. Wilford. Managing Financial Risk: A Guide to Delivative Products, Financial Engineering and Value Maximization, Irwin, 1995.

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