Risk Premia Strategies - Foreign Exchange
The Art of Selectively Harvesting Attractive Risk Premia
Carry and momentum in currency markets:
Carry and momentum strategies are the most popular premium capturing strategies in currency markets. We analyse the popular FX carry strategy consisting of making investments in high-yielding currencies and financing by borrowing in low yielding currencies; and the FX momentum strategy which exploits the persistence of directional moves of the currencies over an appropriately selected time-frame.
Under the efficient market hypothesis, the forward FX rate should be an unbiased expectation of the future FX rate reflecting all publicly available information. In reality though the forward rate has almost no forecasting power of future exchange rates, and contrary to expectations higher-yielding currencies do tend to appreciate on average more versus lower yielding ones, as these higher rates were usually linked to growing economies with better prospects.
All these reasons have naturally led to a rise of the carry trade idea, where purchases in higher yielding currencies are financed by borrowing in lower yielding currencies. Assuming that the higher yielding currency either appreciates or does not change its value versus the funding currency, the investor makes a profit equal at least to the interest-rate differential on the capital invested.
It is well known that carry strategies, whilst offering a positive carry (or theta), also experience infrequent but severe drawdowns. The performance of the strategy is highly linked to global risk appetite and losses accumulate particularly quickly in crisis situations. In part, this is because high-yielding currencies are often also the higher beta currencies with respect to risk sentiment, whilst the funding currencies are often considered to be safe havens and tend to appreciate in crisis situations.
Being in essence a leveraged speculative strategy, positions in FX carry trades are often unwound when there is a potential for losses in other strategies or asset classes. Hence, whilst the strategy offers a positive carry, it has a negative skew and is adversely affected by a rise in volatility. Additionally, various filters and risk-management techniques can help mitigate the problems associated with carry strategies by combining macro, market and technical indicators.
Momentum investing has been one of the most popular systematic strategies applied in financial markets. A momentum strategy exploits the persistence of directional moves of assets over an appropriately selected timeframe. Momentum has been well documented in academic literature for various asset classes and the CTA hedge-fund industry has grown out of the phenomenon.
Several possible explanations to the profitability of momentum strategies have been put forward with the most common being a behavioural explanation – investors initially underreact to market information and subsequently overreact. Whilst possible explanations for the performance of momentum strategies are important, the ultimate goal is actually designing a strategy that is able to deliver consistent returns. Obviously, an FX rate reflects the relative price of one currency versus another and for that reason global trends that are sometimes evident in equities and commodities are not always so reflected in currency markets which renders the design of trend-following in currencies a much more challenging task.
Risk Premia - Forex
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