Currency Portfolios Research Articles

Virtual Standard Currency for Approximating Foreign Exchange Rates

ABSTRACTIn the global financial and business world, the wealth that an entity owns usually is composed of various assets or measured by different currencies, the value of which is dependent on the fluctuation of the foreign exchange rates. The analysis of dynamics associated with the foreign exchange rates is one of the important concerns to market strategists, financial planners, or risk managers such that a fundamental problem is induced as how to measure the wealth objectively. In this paper, a concept of the virtual standard currency (VSC) is proposed as a methodology to measure the wealth in a currency portfolio objectively. The VSC is regarded as a virtual base currency such that any real foreign exchange rate matrix is approximated by a rank one matrix consisting of two virtual exchange rate vectors. The existence of the VSC is proved through an optimal solution to the basic rank one approximation problem. The evaluation of wealth in a currency portfolio is free from the buying or selling operations in real currencies so that the currency portfolio is kept invariant during the measurement. The VSC can eliminate uncertainties arising from the choice of a specific real currency and the interactive effects across different kinds of currencies. Also, the modified power method is designed to search for the virtual exchange rates numerically, the convergence of which is also established. Furthermore, some practical examples are presented to verify the feasibility and efficiency of the modified power method in approximating a foreign exchange rate matrix.

Technical analysis in estimating currency risk portfolios: case study: commercial banks in Romania

Value at Risk method became one of the most used tools in bank management in order to estimate the losses resulting from a foreign currency portfolio. The study aims to estimate the maximum loss for the euro currency due to exchange rate volatility by establishing VaR, starting from the method based on historical simulations. The sample of the research consists of the four commercial banks listed on the Bucharest Stock Exchange (BSE), respectively: Romanian Commercial Bank SA (member of Erste – BCR Group); Romanian Development Bank – Groupe Societe Generale (BRD); Transylvania Bank SA (BT) and Carpatica Bank (BCC), based on a number of 757 observations corresponding to the working days in the period 1 January 2012 – 31 December 2014. The results obtained from the research showed that in case of the analyzed banks the maximum anticipated loss in a future time horizon of 10 days, with a relevance of 1%, does not exceed 2% of the net positions on the euro currency. The study could not be extended to other currencies, because in the information available for the four commercial banks only the net position on the euro currency is separately expressed.

Foster-Hart optimization for currency portfolios

Abstract We examine the effectiveness of Foster-Hart optimization for currency portfolios. Compared to stock trading, short selling is quite common in currency trading. Combining long and short positions leads to maintaining positive expected portfolio returns. Foster-Hart optimization is more applicable to currency portfolios than to stock portfolios because the Foster-Hart risk measure is not defined for the gamble whose expected returns are negative. Our sample portfolio consists of ten European currencies. For time series analysis, we employ a generalized autoregressive conditional heteroscedasticity (GARCH) model with multivariate normal tempered stable (MNTS) distributed residuals in order to capture fat-tailedness, skewness, and asymmetric interdependence of exchange rate dynamics. Statistical tests indicate that the model is recommendable among the candidate models. We establish that Foster-Hart optimization is more profitable than standard techniques in this context.

Risk-Return Trade-Off on the Currency Portfolios

Unconditional asset pricing models have generally found it challenging to identify evidence of risk aversion. This paper addresses this challenge by examining whether currency portfolios display an intertemporal risk-return relationship. We consider time-varying relations because investors' risk-aversion may change over time, based upon changing economic states. Moreover, we take into account a broad based measure of investors' expectation from a data rich environment and factor model. We identify that the relations between risk and return vary over time, and the risk-aversion parameters on momentum and value currency portfolios increased during the financial crisis. Those parameters can command both positive and negative values. Therefore traditional time-invariant models may not identify strong risk-return relations because state dependent evidence is washed out.

THE YIELD OF THE CARRY TRADE STRATEGY

The article analyzes the carry trade strategy in which, according to common definition, traders borrow a currency that has a low-interest rate and use the funds to buy a different currency that is paying a higher interest rate. The aim of this work is to form the optimal strategies and carry trade portfolio. The task of our study was to study the interdependence between the yield of the carry trade strategy and the USA stock market on the basis of a mathematical approach and offer a portfolio of currencies with the highest historical yield over the past five years. The author used the model of relative risk aversion. We analyzed data on exchange rates, forward premium and real exchange rates for the Eurozone, as well as for countries of the Organization for Economic Cooperation and Development (OECD) such as Australia, Brazil, China, Japan, New Zealand, Russia, Switzerland, the United Kingdom and the United States of America. Carry trade’s yield is not tied to standard risk factors. Popular funding currency — the yen has experienced a strong jump of volatility as a result of the 2008–2009 crisis. A possible explanation for this reversal is investors’ appetite for risk. The author concluded that the most common carry trade strategies in the period from 2009 to 2014 were formed on the basis of two financing currencies (Japanese yen and the US dollar) and three investment currencies (Australian dollar, New Zealand dollar and Chinese yuan). After 2014, the US dollar ceases to be the funding currency, giving way to the Euro. The optimal carry trade strategy is borrowing in the currencies of developed countries (EUR, JPY) and investing in the currencies of energy producing countries (RUB, BRL). There is a negative relationship between the volume of transactions based on the carry trade strategy and the yield of shares in the financing country. There is also a significant link between the yield of the carry trade strategy and the profitability of the USA stock market.

The Islamic gold dinar: a hedge against exchange rate volatility

Purpose The purpose of this paper is to investigate the ability of the Islamic gold dinar to hedge against two well-established foreign exchange (FX) risk factors namely, the dollar risk factor and global FX volatility innovations. Design/methodology/approach The paper uses a combination of the Markowitz (1952) portfolio optimization, visual data representations and the classic Fama-Macbeth (1973) two-pass procedure regressions. Findings The findings show that the Islamic gold dinar can serve as a hedge against market volatility, outperforms a diversified currency portfolio, and through its inclusions into the diversified currency portfolio, improve said portfolio’s ability to hedge against market volatility. Research limitations/implications Due to the spread of the sample, country-specific factors could not be taken into account. Practical implications The Islamic gold dinar is a cost-efficient, cost-effective, and Shariah-compliant instrument that provides a solid hedge for investors and/or firms that have financial positions denominated in foreign currencies. Should these investors or firms find it costly to maintain a dinar-only portfolio, including the dinar into their currency portfolios also provides the same benefit, albeit at a lower magnitude. Originality/value This study is timely as the Accounting and Auditing Organization for Islamic Financial Institutions has recently for the first time recognized gold as a Shariah-compliant investment. The findings of this study provide the first look as to how investors and firms can benefit through the use of the Islamic gold dinar in their risk management practices.

Exchange rate forecasting and the performance of currency portfolios

AbstractWe examine the potential gains of using exchange rate forecast models and forecast combination methods in the management of currency portfolios for three exchange rates: the euro versus the US dollar, the British pound, and the Japanese yen. We use a battery of econometric specifications to evaluate whether optimal currency portfolios implied by trading strategies based on exchange rate forecasts outperform single currencies and the equally weighted portfolio. We assess the differences in profitability of optimal currency portfolios for different types of investor preferences, two trading strategies, mean squared error‐based composite forecasts, and different forecast horizons. Our results indicate that there are clear benefits of integrating exchange rate forecasts from state‐of‐the‐art econometric models in currency portfolios. These benefits vary across investor preferences and prediction horizons but are rather similar across trading strategies.

Deviations from Triangular Arbitrage Parity in Foreign Exchange and Bitcoin Markets

This paper applies recently developed procedures to monitor and date so-called financial market dislocations, defined as periods in which substantial deviations from arbitrage parities take place. In particular, we focus on deviations from the triangular arbitrage parity for exchange rate triplets from a cointegration perspective. Due to increasing attention on and importance of mispricing in the market for cryptocurrencies, we include the cryptocurrency Bitcoin in addition to fiat currencies. We do not find evidence for substantial deviations from the triangular arbitrage parity when only traditional fiat currencies are concerned, but document significant deviations from triangular arbitrage parities in the newer markets for Bitcoin. We confirm the importance of our results for portfolio strategies by showing that a currency portfolio that trades based on our detected break-points outperforms a simple buy-and-hold strategy.

Downside risks and the cross-section of asset returns

In an intertemporal equilibrium asset pricing model featuring disappointment aversion and changing macroeconomic uncertainty, we show that besides the market return and market volatility, three disappointment-related factors are also priced: a downstate factor, a market downside factor, and a volatility downside factor. We find that expected returns on various asset classes reflect premiums for bearing undesirable exposures to these factors. The signs of estimated risk premiums are consistent with the theoretical predictions. Our most general, five-factor model is very successful in jointly pricing stock, option, and currency portfolios, and provides considerable improvement over nested specifications previously discussed in the literature.

Evaluating the efficiency of currency portfolios constructed by the mining association rules

We propose a new portfolio, an association currency portfolio (ACP), constructed by the recommendations of the mining association rules, to strengthen mean-variance efficiency. We empirically analyze the efficiency of currency portfolios using 15 countries' exchange rates denominated by the Taiwanese Dollar. Our findings suggest that the ACPs outperform other portfolios constructed by the Pearson's correlation model. The mining association rule is useful for recommending candidate currencies for international investors, to help them establish efficient portfolios.

Volatility-Managed Portfolios of Mutual Funds

Performance evaluation of mutual funds using factor pricing models is usually distorted by the existence of a volatility anomaly and correlated residuals. By augmenting the Fama-French five-factor model with an active peer benchmark, we eliminate the measurement errors caused by these distortions. We find that the APB-augmented five-factor model can select mutual fund portfolios with superior out of sample alphas. However, the excess portfolio returns are volatile and subject to crash risk. A risk management strategy which uses the past volatility of the mutual fund portfolio returns to scale the investment positions can help reduce the volatility of the portfolio returns and avoid extreme losses. Previous studies on stock and currency portfolios find that such a risk management technique also increases the Sharpe ratio of the portfolios. However, we find that the net impact of the risk management on the Sharpe ratio of mutual fund portfolios depends on the investment style of the mutual funds in the fund portfolios. Similar to the stock and currency portfolios, the Sharpe ratios of the mutual fund portfolios can be increased by the risk management if the portfolios are formed in mutual funds which specialize in large cap stocks. By contrast, risk management reduces the Sharpe ratios of portfolios which include small stocks-focused funds. The reason is that the mutual funds which specialize in small stocks relies more on their abilities to take on more factor risks when the factor returns are high to generate returns. Volatility timing reduces the premium of those funds’ market timing skills. Compared to investors in mutual funds which specialize in value stocks, investors in growth stocks-focused mutual funds can better enhance their market timing skills by the risk management technique. More specifically, after volatility timing, the growth stocks-focused mutual fund investors are able to take on more factor risks when the factor returns are high and gain higher average returns.

An intrinsic robust rank-one-approximation approach for currency portfolio optimization

A currency portfolio is a special kind of wealth whose value fluctuates with foreignexchange rates over time, which possesses 3Vs (volume, variety and velocity) properties of big datain the currency market. In this paper, an intrinsic robust rank one approximation (ROA) approachis proposed to maximize the value of currency portfolios over time. The main results of the paperinclude four parts: Firstly, under the assumptions about the currency market, the currency portfoliooptimization problem is formulated as the basic model, in which there are two types of variablesdescribing currency amounts in portfolios and the amount of each currency exchanged into another,respectively. Secondly, the rank one approximation problem and its variants are also formulated toapproximate a foreign exchange rate matrix, whose performance is measured by the Frobenius normor the 2-norm of a residual matrix. The intrinsic robustness of the rank one approximation is provedtogether with summarizing properties of the basic ROA problem and designing a modified powermethod to search for the virtual exchange rates hidden in a foreign exchange rate matrix. Thirdly,a technique for decision variables reduction is presented to attack the currency portfolio optimization.The reduced formulation is referred to as the ROA model, which keeps only variables describingcurrency amounts in portfolios. The optimal solution to the ROA model also induces a feasible solutionto the basic model of the currency portfolio problem by integrating forex operations from the ROAmodel with practical forex rates. Finally, numerical examples are presented to verify the feasibility ande ciency of the intrinsic robust rank one approximation approach. They also indicate that there existsan objective measure for evaluating and optimizing currency portfolios over time, which is related tothe virtual standard currency and independent of any real currency selected specially for measurement.

Construction of currency portfolios by means of an optimized investment strategy

This work focuses on the development of a technical breakout trading strategy based on the Donchian Channel approach, aiming to the construction of profitable portfolios. In this direction, the Modified Renko Bars (MRBs) were developed first; that proved to be a useful trading tool that responses more accurately than the normal candle sticks to the nature and characteristics of the FOREX market. Subsequently, the parameters of the trading strategy (or system) are calibrated for eight currency pairs, over a period of four years (2006–2009), by comparing the performance of three global search derivative-free optimization algorithms. Then, the returns of the developed system are tested for the next seven years (2010–2016) for each pair and two types of portfolios are constructed; an equal weighted one and a portfolio based on the Kelly criterion. The ultimate objective of this paper is to create currency portfolios based on a novel optimized trading strategy, which could beat constantly the main investors’ benchmarks (i.e. S&P500, Barclay CTA Index).

Optimal Currency Hedging for International Equity Portfolios

We explore optimal currency exposures in international equity portfolios through the lens of a modified mean-variance optimization framework. We decompose the optimal currency portfolio into a “hedge portfolio” which minimizes equity volatility using a dynamic risk model and an “alpha seeking portfolio” based on the well-documented currency styles of value, momentum and carry. This is an integrated and economically intuitive approach to currency management that simultaneously provides lower risk and higher returns compared to both hedged and unhedged benchmarks. Crucially, the solution is practical with realistic and implementable leverage, turnover and tail risk characteristics.

An intrinsic robust rank-one-approximation approach for currency portfolio optimization

An intrinsic robust rank-one-approximation approach for currency portfolio optimization

Global Currency Hedging with Common Risk Factors

We develop a novel method to dynamically hedge foreign exchange exposure in international equity and bond portfolios. The method exploits the time-series predictability of currency returns, which we show emerges from exploiting a forecastable component in global factor returns. The hedging strategy outperforms leading alternative approaches to currency hedging across a large set of out-of-sample performance metrics. Moreover, we find that exploiting currency return predictability via an independent currency portfolio delivers a high risk-adjusted return and provides superior diversification gains to global equity and bond investors relative to currency carry, value, and momentum investment strategies.

Forward-Looking Currency Betas

I propose a model-free method to derive forward-looking betas to currency portfolios from cross-pair currency options. Using the dollar factor --- an equal-weighted basket of foreign currencies against the U.S. dollar --- as the systematic factor, I find that these option-implied betas are significantly better predictors of realized betas and currency excess returns compared to traditional rolling window betas. Constructing portfolios based on option-implied betas leads to a significantly positive relation between ex-ante betas and ex-post portfolio returns, whereas there is an insignificant relation when rolling window betas are used.

Do Precious and Industrial Metals Act as Hedges and Safe Havens for Currency Portfolios?

This study explores whether metals act as hedges and safe havens for currency investing portfolios. Three widely used currency investment strategies: carry, momentum and value are adopted. The empirical results argue that gold and silver do exhibit hedge and safe haven properties for all three strategies. Silver works as a strong hedge during extreme market conditions. However, these hedge and safe haven properties became weaker after the year 2000. We also find that industrial metals do not work as either hedges or safe havens for carry portfolios.

Do precious and industrial metals act as hedges and safe havens for currency portfolios?

This study explores whether metals act as hedges and safe havens for currency investing portfolios. Three widely used currency investment strategies: carry, momentum and value are adopted. The empirical results argue that gold and silver do exhibit hedge and safe haven properties for all three strategies. Silver works as a strong hedge during extreme market conditions. However, these hedge and safe haven properties became weaker after the year 2000. We also find that industrial metals do not work as either hedges or safe havens for carry portfolios.

Multivariate Jump Diffusion Model with Markovian Contagion

Asset prices exhibit characteristics that significantly deviate from log-normality and display time-varying stochastics. There is ample evidence of jumps in one asset price or market leading to jumps in other assets' prices or markets. We propose a multivariate jump diffusion model with Markovian contagion to capture these asset price dynamics, where the channel of contagion is taken to periodically switch from an active to inactive state. We use a dynamic conditional correlation network approach to determine the contagion states and estimate the Markovian contagion model. Applying the model to an international equity and currency portfolio allocation shows the capabilities of the model in capturing fat tail characteristics of asset returns, as well as evaluate the extent of model risk, intra-asset class, inter-asset and inter-region contagion.