Currency Exchange Style Factors for Incremental Diversification

Do currency exchange factor strategies usefully diversify a set of conventional asset classes? In their May 2018 paper entitled “Currency Management with Style”, Harald Lohre and Martin Kolrep investigate the systematic harvesting of currency exchange carry, value and momentum strategies, specified as follows and applied to the G10 currencies:

• Carry – buy (sell) the three equally weighted currency forwards with the highest (lowest) short-term interest rates, reformed monthly.
• Momentum – buy (sell) the three equally weighted currency forwards with the greatest (least) appreciation over the past three months, reformed monthly.
• Value (long-term reversion) – buy (sell) the three equally weighted currency forwards with the lowest (highest) change in their real exchange rates, based on purchasing power parity, over the past 60 months, reformed monthly.

They examine in-sample (full-sample) mean-variance relationships for these strategies to assess their value as diversifiers of five conventional asset classes (U.S. stocks, commodities, U.S. Treasury bonds, U.S. corporate investment-grade bonds and U.S. corporate high-yield bonds). They also look at potential out-of-sample benefits of these strategies based on information available at the time of each monthly rebalancing as additions to a risk parity portfolio of the five conventional assets from the perspective. For this out-of-sample test, they consider both minimum variance (tail risk hedging) and mean-variance optimization (return seeking) for aggregating the three currency strategies. Using monthly data for the selected assets from the end of January 1999 through December 2016, they find that: (more…)