Prospect theory value as investment factor

October 17, 2020

Prospect theory value as investment factor

Prospect theory value is a valid investment factor, particularly in episodes of apparent market inefficiency. Prospect theory is a popular model of irrational decision making. It emphasizes a realistic mental representation of expected gains and losses and an individual’s evaluation of such representations. Prospect theory explains asymmetric loss aversion (view post here) and gambling preferences (view post here). Since mental representations of expected returns and volatility are often driven by price charts, prospect theory value can be estimated based on historic asset return distributions. Assets with a high prospect theory value should have low subsequent returns and vice versa. This proposition holds even if part of the market is fully rational as long as there are balance sheet and risk limits. Empirical academic papers have confirmed the prospect theory value in international equity, corporate bond and foreign exchange markets.

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Understanding international capital flows and shocks

October 3, 2020

Macro trading factors for FX must foremostly consider (gross) external investment positions. That is because modern international capital flows are mainly about financing, i.e. exchanges of money and financial assets, rather than saving, real investments and consumption (which are goods market concepts). Trades in financial assets are much larger than physical resource trades. Also, financing flows simultaneously create aggregate purchasing power, bank assets and liabilities. The vulnerability of currencies depends on gross rather than net external debt. Current account balances, which indicate current net payment flows, can be misleading. The nature and gravity of financial inflow shocks, physical saving shocks, credit shocks and – most importantly – ‘sudden stops’ all depend critically on international financing.

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How banks’ dollar holdings drive exchange rate dynamics

July 11, 2020

Non-U.S. financial institutions hold precautionary positions in U.S. dollar assets as protection against financial shocks. This gives rise to a safety premium on the dollar. The premium varies over time and, hence, not only accounts for contemporaneous exchange rate dynamics but also helps to predict exchange rate trends. An IMF paper measures non-U.S. banks’ dollar demand for 26 economies as the ratio of assets denominated in dollar to total assets by nationality. Demand for U.S. dollars tends to surge following negative financial market shocks and causes dollar strength. Non-U.S. holdings of dollar assets have also been a highly significant predictor of dollar trends in subsequent years. Thus, large holdings have heralded dollar depreciation in the past.

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External imbalances and FX returns

June 13, 2020

Hedge ratios of international investment positions have increased over past decades, spurred by regulation and expanding derivative markets. This has given rise to predictable movements in spot and forward exchange rates. First, on balance hedgers are long currencies with positive net international investment positions and short those with negative international investment positions. With intermediaries requiring some profit for balance sheet usage these trades command negative premia and widen cross-currency bases. Second, hedge ratios increase in times of rising FX volatility. An increase in the hedge ratio for a currency puts downward pressure on its market price in proportion to its external imbalance and bodes for higher medium-term returns. Also, the dispersion of cross-currency bases increases in times of turmoil.

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FX trading strategies based on output gaps

October 19, 2019

Macroeconomic theory suggests that currencies of countries in a strong cyclical position should appreciate against those in a weak position. One metric for cyclical strength is the output gap, i.e. the production level relative to output at a sustainable operating rate. In the past, even a simple proxy of this gap, based on the manufacturing sector, seems to have provided an information advantage in FX markets. Empirical analysis suggests that [1] following the output gap in simple strategies would have turned a trading profit in the long-term, and [2] the return profile would have been quite different from classical FX trading factors.

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Bad and good beta in FX strategies

June 29, 2019

Bad beta means market exposure that is expensive to hedge. Good beta is market exposure that is cheap to hedge. Distinguishing between these is crucial for FX trading strategies. The market sensitivity of FX positions can be decomposed into a risk premium beta (‘bad beta’) and a real rate beta (‘good beta’). FX positions with risk premium betas are associated with a positive price of risk that increases in crisis periods. FX positions with real rate beta are hedges, whose value increases in crisis times. Many conventional currency trading strategies carry either excessive ‘bad beta’ or too little ‘good beta’ and, thus, fail to produce true investor value.

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CDS term premia and exchange rates

November 24, 2018

The term structure of sovereign credit default swaps (CDS) is indicative of country-specific financial shocks because rising country risk affects short-dated maturities more than longer-dated ones. This feature allows disentangling global and local risk factors in sovereign CDS markets. The latter align with the performance of other local asset markets. In particular, recent empirical research supports the predictive value of CDS term premia for exchange rate changes. The finding is plausible, because both local-currency assets and CDS term premia have common pricing factors, while CDS curves are cleaner representations of country financial risks.

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How lazy trading explains FX market puzzles

September 29, 2018

Not all market participants respond to changing conditions instantaneously, not even in the FX market. Private investors in particular can take a long while to adapt to changes in global interest rate conditions and even institutional investors may be constrained by rules and lengthy process. A theoretical paper shows that delayed trading goes a long way in explaining many empirical puzzles in foreign exchange markets, i.e. deviations from the rational market equilibrium, such as the delayed overshooting puzzle or the forward discount puzzle. Understanding these delays and their effects offers profit opportunities for flexible information-efficient traders.

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U.S. dollar exchange rate before FOMC decisions

August 15, 2018

Since the mid-1990s the dollar exchange rate has mostly anticipated the outcome of FOMC meetings: it appreciated in the days before a rate hike and depreciated in the days before a rate cut. This suggests that since fixed income markets usually predict policy rate moves early and correctly their information content can be used to trade the exchange rate. A recent paper proposes a systematic trading rule for trading USD before FOMC meetings based upon what is priced into the each Fed meeting from Fed fund futures and claims that such a strategy would have delivered a respectable Sharpe ratio.

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A simple rule for exchange rate trends

June 2, 2018

Over the past decades developed market exchange rates have displayed two important regularities. First, real exchange rates (nominal exchange rates adjusted for domestic price trends) have been mean reverting. Second, the mean reversion has predominantly come in form of nominal exchange rate trends. Hence, a simple rule of thumb for exchange rate trends can be based on the expected re-alignment the real exchange rates with long-term averages over 2-5 years. According to a new paper, FX trend forecasting models based on this rule outperform both the random walk and more complex forecasting models.

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