Managing the Risk of Currency Momentum Strategies

Abstract

This paper investigates two risk-management techniques originally created for stock market momentum strategies, i.e. a) constant volatility targeting (scaling) and b) the implementation of stop-losses in the cross-section of portfolio components. It applies them to momentum strategies in currency markets and compares their effectiveness. It finds that constant volatility targeting (scaling) has no beneficial effect. In fact, detailed analysis suggests that it is a method uniquely suited to stock market momentum. Stop-losses are also far less useful than in stock markets. Finally, it suggests that not macroeconomic risk factors, but limits to arbitrage (stemming from high idiosyncratic volatility) are a potential source of currency momentum’s high returns.