by Christopher Chen
In the immediate aftermath of World War II, 730 delegates from the Allied nations convened in a New Hampshire hotel to discuss the post-war monetary system. The delegates, led by John Maynard Keynes, developed the Bretton Woods system of monetary management, which was adopted by the United States, Canada, Western Europe, Australia and Japan in the mid-20th century. Part of the Bretton Woods agreement was that currency exchange was to be pegged to the US dollar because it was backed by gold at the time. In 1973, the Bretton Woods system was dissolved and as a result, foreign governments were no long obliged to peg their exchange rate to the US dollar. Since countries could now determine their exchange rates, currency pairs became more volatile and thus more popular for investors to trade in.
This article gives a brief description of three currency speculation strategies: technical, currency carry, and momentum, and using data from research papers from various finance professors, intends to explain reasons for their excess returns.
Technical Trading Strategy
Technical trading is a currency trading strategy which analyzes past asset prices and trading volumes to predict future asset prices and trading volumes. Currently, technical analysis is not accepted by most academic economists and investors because the concept that past prices have any relevance in determining future prices violates the efficient market hypothesis. However, technical trading is popular among retail investors. According to a research paper by Carol Osler, 89% retail traders are technical traders and of those technical traders, 40% exclusively rely on technical analysis.
Even though this trading strategy may not be profitable in the short term, it has a high degree of reliability of forecasting in the short term. Academic economists speculate excess returns are generated by this trading technique due to the concept of the self-fulfilling prophecy. As investors seek a particular technical signal, all of them will execute the same trade and thus be able to make a profit.
Currency Carry Strategy
Currency carry trade is when an investor sells a currency at a low interest rate and uses the funds to purchase a higher interest rate currency. By itself, the currency carry strategy is currently the most profitable trading strategy used.
Excess returns in the currency carry strategy are influenced by traditional investing factors such as global risk and business cycle. However, economists think this strategy is going to be less profitable and popular over time because small market setbacks when trading with this strategy can cause for massive losses.
Momentum trading strategy takes advantage of upward trends or downward trends in a currency’s price. Usually, the “sweet-spot” time period for momentum trading is 8-12 months. Holding the currency longer will result in an excess returns decline. On the other hand, anything less will be too volatile.
Momentum strategies in foreign exchange rely on continuation returns among winner and loser currencies. Thus, traditional finance theory and risks such as standard business cycles and portfolio risks do not explain the excess returns that momentum trading generates. Instead, to understand why momentum trading generates excess returns, it is important to understand systemic risks, which are inherent to an entire market. According to financial researchers, transaction costs influence returns to momentum trading. This is because most bid-ask spreads are too high relative to effective spreads. In other words, there needs to be more of a realistic bid-ask spread quoted by brokers. Momentum strategy is also affected by volatility. This is because there is a greater possibility that excess returns are to be made when an asset is more volatile. Thus, it is more popular to invest in emerging markets and smaller currencies. These developing currencies are more volatile and thus have the ability to gain more “momentum”.
Using 20 major currencies, the carry trade strategy had an average pay-off of 4.6% on forex trading with a standard deviation (riskiness) of 5.1% and a Sharpe ratio of 0.89 (return adjusting for risk) from 1976-2010. In that same time frame, the US superior farm stock market had an average pay-off of 6.5% with a standard deviation of 15.7% Sharpe ratio of 0.41. Momentum strategy had an average pay-off of 4.5%, a standard deviation of 7.3% and Sharpe ratio of 0.62. Lastly, the combination of the two currency strategies, “50-50 strategy”, had an average payoff of 4.5%, a standard deviation of 4.6% and a Sharpe ratio of 0.98.