FX carry strategies (part 1)

June 9, 2018

FX forward-implied carry is a valid basis for investment strategies because it is related to policy subsidies and risk premia. However, it also contains misdirection such as rational expectations of currency depreciation. To increase the signal-noise ratio FX carry should – at the very least – be adjusted for expected inflation differentials and external deficits. Even with such plausible adjustments FX carry is a hazardous signal for directional trades because it favours positions with correlated risks and great sensitivity to global equity markets. By contrast, relative adjusted carry has been a plausible and successful basis for setting up relative normalized carry trades across similar currencies. It has historically produced respectable Sharpe ratios and low directional risk correlation. Such strategies seem to generate alpha and exploit alternative risk premia alike.

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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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Using yield curve information for FX trading

May 12, 2018

FX carry trading strategies only use short-term interest rates (and forward basis) as signal. Yet both theoretical and empirical research suggests that the whole relative yield curve contains important information on monetary policy and risk premia. In particular, the curvature of a yield curve indicates – to some extent – the speed of adjustment of the short rate towards a longer-term yield. Since relative curvature between two countries is therefore a measure of the relative trajectory of monetary policy it is a valid directional signal for FX trading. Indeed, recent empirical research suggests that this signal is statistically significant. A curvature-based trading rule produces higher Sharpe ratios and less negative skewness than conventional FX carry strategies.

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Hedging FX trades against unwanted risk

September 23, 2017

When FX forward positions express views on country-specific developments one can shape the trade to its rationale by hedging against significant unrelated global influences. Almost all major exchange rates are sensitive to directional global market moves and USD-based exchange rates are typically also exposed to EURUSD changes. A simple empirical analysis for 29 currencies for 1999-2017 suggests that the largest part of these influences has been predictable out-of-sample and hence “hedgeable”. Even volatility-adjusted relative positions across EM or FX carry currencies may sometimes be hedged against market directional influences.

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FX forward returns: basic empirical lessons

September 9, 2017

FX forward returns for 29 floating and convertible currencies since 1999 provide important empirical lessons. First, the long-term performance of FX returns has been dependent on economic structure and clearly correlated with forward-implied carry. The carry-return link has weakened considerably in the 2010s. Second, monthly returns for all currencies showed large and frequent outliers beyond the borders of a normal random distribution. Simple volatility targeting would not have mitigated this. Third, despite large fundamental differences, all carry and EM currencies have been positively correlated among themselves and with global risk benchmarks. Fourth, relative standard deviations across currencies have been predictable and partly structural. Hence, they have been important for scaling FX trades across small currencies.

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Covered interest parity: breakdowns and opportunities

August 12, 2017

Since the great financial crisis conventional measures of the covered interest parity across currencies have regularly broken down. Two developments seem to explain this. First, money markets have become more segmented, with top tier banks having access to cheaper and easier funding, particularly in times distress. Second, FX swap markets have experienced recurrent imbalances and market makers have been unable or unwilling to buffer one-sided order flows. Profit opportunities arise for some global banks in form of arbitrage and for other investors in form of trading signals for funding liquidity risk premia.

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Explaining FX forward bias

July 8, 2017

Forward bias in foreign exchange markets means that a positive interest rate differential precedes currency appreciation. It has been an empirical regularity in developed FX markets in recent decades. The forward bias contradicts traditional theory: positive risk-adjusted interest rate differentials are supposed to be offset by expected currency depreciation. An academic paper explains how FX forward bias arises when central banks ‘lean against the wind’ of appreciation through sterilized FX interventions.

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FX strategies based on quanto contract information

June 17, 2017

Quantos are derivatives that settle in currencies different from the denomination of the underlying contract. Therefore, quanto index contracts for the S&P 500 provide information on the premia that investors are willing to pay for a currency’s risk and hedge value with respect to U.S. stocks. Currencies that command high risk premia and provide little hedge value should have superior future returns. These premia can be directly inferred from quanto forward prices, without estimation. Empirical evidence supports the case for quanto contracts as a valid signal generator of FX strategies.

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Simple international macroeconomics for trading

June 10, 2017

Simple New Keynesian macroeconomic models work well for analyzing the impact of various types of shocks on small open economies and emerging markets. The models are a bit more complex than those for large economies, because one must consider the exchange rate, terms-of-trade and financial pressure. Yet understanding some basic connections between market factors and the overall economy already supports intuition for macro trading strategies. Moreover, the analysis of the effect of various shocks is possible in simple diagrams.

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Explosive dynamics in exchange rates

May 20, 2017

Explosiveness in financial markets means that prices display exponential growth. In recent years statistical tests have been developed to locate mildly explosive bubble periods in real time. In conjunction with judgment on underlying fundamentals they help detecting price distortions. A new paper shows how tests for explosiveness can be applied to exchange rates. The tests suggest that developed market currencies have recurrently experienced episodes of explosive behaviour, reaching from a few days to up to three months. Currency level changes seem to reverse subsequently. Periods of explosiveness since 2000 have often been related to the U.S. dollar and financial market volatility.

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asset management Asset Purchase Program banks bond returns bond yields bubbles capital regulation carry China collateral commodities credit returns default ECB economic data EM equity returns euro area crisis Fed financial crisis FX FX interventions FX returns government debt government deficits herding inflation information insurances Japan leverage liquidity machine learning market turmoil price factors regulation risk management shadow banking statistical methods term structure trend following variance risk premium VIX volatility ZLB
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