Currency Momentum Research Articles

Currency Management by International Fixed‐Income Mutual Funds

ABSTRACTInvestments in international fixed‐income securities are exposed to significant currency risks. We collect novel data on currency derivatives used by U.S. international fixed‐income funds. We document that while 90% of funds use currency forwards, they hedge, on average, only 18% of their currency exposure. Funds' currency forward positions differ substantially based on risk management demands related to portfolio currency exposure, return‐enhancement motives such as currency momentum and carry trade, and strategic considerations related to past performance and fund clientele. Funds that hedge their currency risk exhibit lower return variability, but do not generate inferior abnormal returns.

Currency portfolios and global foreign exchange ambiguity

This study investigates whether cross-sectional global foreign exchange (FX) ambiguity impacts currency portfolios. We observe that, in contrast to FX volatility, high FX ambiguity leads to high currency carry returns. We also reveal that FX ambiguity is weakly associated with the highest interest rate portfolio, but strongly related to the second highest interest rate portfolio. These results suggest that FX ambiguity captures elements of uncertainty that are not captured by FX volatility. In addition, FX ambiguity is not linked to returns on currency momentum and value portfolios.

Sovereign default network and currency risk premia

We construct a sovereign default network by employing high-dimensional vector autoregressions obtained by analyzing connectedness in sovereign credit default swap markets. We develop four measures of centrality, namely, degree, betweenness, closeness, and eigenvector centralities, to detect whether network properties drive the currency risk premia. We observe that closeness and betweenness centralities can negatively drive currency excess returns but do not exhibit a relationship with forward spread. Thus, our developed network centralities are independent of an unconditional carry trade risk factor. Based on our findings, we develop a trading strategy by taking a long position on peripheral countries’ currencies and a short position on core countries’ currencies. The aforementioned strategy generates a higher Sharpe ratio than the currency momentum strategy. Our proposed strategy is robust to foreign exchange regimes and the coronavirus disease 2019 pandemic.

Factor investing and currency portfolio management

Currency-specific pricing factors are pervasive in international asset pricing. However, portfolio and risk management based on forex factors, instead of individual currencies, are rarely discussed. This paper tries to fill this gap by modelling dynamic correlations and non-normality among forex factors. By considering the four most popular forex factors: the dollar risk factor, the carry trade factor, the currency momentum factor, and the currency value factor, we find that a dynamic conditional correlation copula (DCC-copula) model with skewed-t kernel fits the joint distribution well. We show that, for risk-averse investors who focus on factor investing or employ the forex factors to resize the specific risk exposure, ignoring the tail dependence structure of forex factors brings significant costs.

Currency Momentum: An Emerging Market Issue?

Three main currency strategies have been established in the literature: carry, value, and momentum. We investigate momentum using data on 27 currencies (10 developed countries and 17 emerging markets). We find that momentum returns are driven by emerging market currencies, while the currencies of developed countries have no impact. An emerging market- specific dollar risk factor can partly explain these momentum returns. We carry out permutation tests and find support for our hypothesis that momentum returns are driven by emerging markets. However, we show that transaction costs reduce momentum returns considerably. We also show that the returns are time-varying and have been unattractive recently. The implications of this study for financial practitioners are to focus on emerging market currencies and optimise transaction costs when executing momentum strategies.

Technical trading rule profitability in currencies: It’s all about momentum

Recent academic and practitioner attention has focused on currency momentum. In this paper we replicate technical trading rules to assess their relationship with momentum. We find the effectiveness of technical trading rules falls significantly over time, with the mean Sharpe Ratio of our sample of portfolios falling from 0.66 in our in-sample period to 0.06 out-of-sample. Further, the returns do not survive modest transaction costs out-of-sample. We identify time series momentum as the single common factor driving returns across the range of strategies. Any abnormal return generated by technical trading rules is fully explained by time series momentum.

Currency momentum strategies based on the Chinese Yuan: Timing of foreign exchange volatility

This study provides an empirical investigation of currency momentum strategies traded on the Chinese Yuan (RMB). Using a cross trading strategy, we find that the RMB-based currency momentum (RCMOM) strategies are profitable and yield excess returns of up to 5% per annum (p.a.). The results are robust to risk adjustment and sub-periods analysis. We further calculate the foreign exchange volatility to explain the profits of RCMOM strategies. Our evidence shows that increased foreign exchange volatility is associated with higher RCMOM profits, and the strategies are more profitable with high volatility of the Chinese stock market. Considering the influence of Chinese market states in foreign exchange volatility, the RCMOM returns are insignificant. Our results suggest that the impact of foreign exchange risk is correlated to China’s market states.

Currency Management by International Fixed Income Mutual Funds

Investments in international fixed income securities are exposed to significant currency risks. We collect novel data on mutual fund currency derivatives and document that around 90% of U.S. international fixed income funds use currency forwards to manage their foreign exchange exposure. Funds' currency forward positions differ substantially based on risk management demands related to portfolio currency exposures, return-enhancement motives such as currency momentum and carry trade, and strategic considerations related to past performance and fund clienteles. Funds that hedge their currency risk exhibit lower return variability, but do not generate inferior abnormal returns.

Currency Management by International Fixed Income Mutual Funds

Investments in international fixed income securities are exposed to significant currency risks. We collect novel data on mutual fund currency derivatives and document that around 90% of U.S. international fixed income funds use currency forwards to manage their foreign exchange exposure. Funds' currency forward positions differ substantially based on risk management demands related to portfolio currency exposures, return-enhancement motives such as currency momentum and carry trade, and strategic considerations related to past performance and fund clienteles. Funds that hedge their currency risk exhibit lower return variability, but do not generate inferior abnormal returns.

Long Run and Short Run Risk Premium in Currency Market

In this paper, I investigate risk premium of long run and short run volatility component of exchange rate returns in currency market. I find that high interest rate currencies of carry trade strategy load negatively on long run volatility innovation, while low interest rate currencies load positively. Risk price of long run volatility innovation is negative which implies that high carry trade returns are considered as compensation for time varying long run volatility risk. In contrast, risk price of short run volatility innovation is positive. Low interest currencies deliver low returns and high interest rate currencies yield high returns under times of high short run volatility. In terms of momentum strategy, risk price of short run volatility innovation is negative and statistically significant, while risk price of long run component is insignificant. Therefore, long run volatility does not provide any explanation for high returns of currency momentum strategy. High momentum returns, on the other hand are reward for investors to bear short run volatility risk.

Let the Parametric Phoenix Fly

In international portfolios investors move away from domestic-only investing and diversify their allocation of assets by foreign equities. The exposure to foreign currencies adds an additional risk component which is managed in the currency overlay. To achieve an ideal weighting of the allocation of assets and the exposure to currencies, this study proposes a novel approach for a joint optimization. For the optimal weighting of equities we suggest to employ characteristics of momentum, value, and size strategies while currencies are allocated according to characteristics of carry trade, currency momentum, and currency value strategies. Relative to a benchmark and in an out-of-sample setting, we document an increase in the portfolios’ Sharpe ratio by 30% after transaction and rebalancing costs. This relative improvement is primarily driven by the increase in portfolios’ returns, while the portfolios’ overall volatility remains unaffected.

Cross-sectional return dispersion and currency momentum

Abstract I assess the relation between cross-sectional return dispersion in foreign exchange (FX) markets and currency momentum. I find that cross-sectional dispersion is priced in the cross-section of currency momentum returns and that an unexpected increase in cross-sectional dispersion is associated with positive (negative) excess returns to winner (loser) currencies. This mechanism can be related to monetary policy conditions. The empirical findings are robust to the inclusion of traditional currency risk factors, liquidity and market volatility variables, and transaction costs. Finally, the explanatory ability of cross-sectional dispersion extends to broader cross-sections of currency portfolios and to individual currencies.

Diversification role of currency momentum for carry trade: Evidence from financial crises

The main objective of this paper is to investigate the diversification role of currency momentum for carry trade crashes during the turbulent periods surrounding the 1997–1998 Asian financial crisis and the 2007–2008 global financial crisis. The motivation is to use an important tendency of momentum strategy to yield statistically and economically significant profits during crisis periods that are far higher than the crashes commonly experienced with the carry trade. I use an empirical heterogeneous agent model to design a new trading strategy which combines carry trade and momentum signals where the relative weight given to both signals is based on their past performance. The main finding is that the combined strategy is a good hedge with desirable diversification merits in times of financial stress. This evidence has important implications for the practices of currency portfolio management during times of heightened financial uncertainty.

Global Political Risk and Currency Momentum

Using a measure of political risk, relative to the United States, that captures unexpected political conditions, we show that political risk is priced in the cross section of currency momentum and contains information beyond other risk factors. Our results are robust after controlling for transaction costs, reversals, and alternative limits to arbitrage. The global political environment affects the profitability of the momentum strategy in the foreign exchange market; investors following such strategies are compensated for the exposure to the global political risk of those currencies they hold, that is, the past winners, and exploit the lower returns of loser portfolios. The risk compensation is mainly justified by the different exposures of foreign currencies in the momentum portfolio to U.S. political shocks, which is the main component of global political risk.

Managing the Risk of Currency Momentum Strategies

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.

Identifying Portfolio-Based Risk Factors in Foreign Exchange Markets

This paper shows that a link between the conditional mean and conditional volatility of any factor-mimicking portfolio in the foreign exchange (FX) market must exist if the proposed portfolio-based currency factor is priced and the pricing kernel has a linear factor structure. Thereby, this paper tests whether the carry risk factor and currency momentum are priced risk factors. Surprisingly, the carry risk factor does not meet the necessary conditions consistent with being a priced risk factor, whereas currency momentum indeed meets those criteria. The findings also indicate that the relation between the conditional mean and conditional risk is moreover economically reasonable for the currency momentum portfolio.

Return dispersion risk in FX and global equity markets: Does it explain currency momentum?

We investigate the potential link between momentum in currency returns and global economic risk as measured by currency return dispersion (RD). Initial tests contribute to the exchange rate puzzle by showing that a common macroeconomic risk component in currency markets is present in global equity markets. Subsequent tests indicate that the spread on zero-cost currency momentum strategies is larger and highly significant in high RD states compared to low RD states. Also, the relation between these momentum payoffs and global economic risk appears to increase linearly in risk. Based on this evidence, we conclude that global economic risk as proxied by RD helps to explain currency momentum profits.

Hedging with an Edge: Parametric Currency Overlay

Campbell, Serfaty-De Medeiros, and Viceira (2010) propose an optimized method to hedge currency risk in portfolios of international equities. In a demanding out-of-sample test, incorporating transaction and rebalancing costs, and margin requirements we find their method reduces risk in real time, but also underperforms economically a naive alternative or even a purely domestic portfolio. We propose modeling the currency hedging strategy as a function of characteristics proxying for expected returns and risk. We find that using currency momentum, value, carry, and autocorrelation significantly reduces the cost of hedging. Proxies for risk, such as volatility, skewness, beta on volatility, and equity sensitivity are irrelevant in our optimizations. Our optimal strategy is close to a fully hedged portfolio, but with a sizable 38% gain in Sharpe ratio.

Cross-Sectional Return Dispersion and Currency Momentum

I assess the relation between cross-sectional return dispersion in foreign exchange (FX) markets and currency momentum. I find that cross-sectional dispersion is priced in the cross-section of currency momentum returns and that an unexpected increase in cross-sectional dispersion is associated with positive (negative) excess returns to winner (loser) currencies. This mechanism can be related to monetary policy conditions. The empirical findings are robust to the inclusion of traditional currency risk factors, liquidity and market volatility variables, and transaction costs. Finally, the explanatory ability of cross-sectional dispersion extends to broader cross-sections of currency portfolios and to individual currencies.

Currency Strategies and Sovereign Ratings

This paper investigates a link between the most popular currency strategies (carry trade, momentum, value) and sovereign ratings. I document that the profitability of the momentum strategy is large and significant among higher credit risk currencies, but is nonexistent among lower credit risk currencies. The profitability of currency momentum disappears when currencies rated BBB- or worse (16% of currency months) are excluded from the sample. The country credit risk conditions do not apply to the carry trade and value, which are profitable among lower and higher credit risk currencies. Sovereign rating changes do not have a significant impact on the performance of the most popular currency strategies.