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Currency Trading

Currency trading (forex or FX) offers investors a way to trade on country or regional fiscal/monetary situations and tendencies. Are there reliable ways to exploit this market? Does it represent a distinct asset class?

Predicting Anomaly Premiums Across Asset Classes

Are anomaly premiums (expected winners minus losers among assets within a class, based on some asset characteristic) more or less predictable than broad market returns? In their April 2017 paper entitled “Predicting Relative Returns”, Valentin Haddad, Serhiy Kozak and Shrihari Santosh apply principal component analysis to assess the predictability of premiums for published asset pricing anomalies spanning stocks, U.S. Treasuries and currencies. For tractability, they simplify asset classes by forming portfolios of assets within them, as follows:

  • For stocks, they consider the long and short legs of portfolios reformed monthly into tenths (deciles) based on each of the characteristics associated with 26 published stock return anomalies (monthly data for 1973 through 2015).
  • They sort zero-coupon U.S. Treasuries by maturity from one to 15 years to assess term premiums (yield data for 1985 through 2014).
  • They sort individual exchange rates into five portfolios reformed daily based on interest rate differentials with the U.S. to assess the carry trade premium (daily data as available for December 1975 through December 2016).

Using the specified data, they find that: Keep Reading

Trading Price Jumps

Is there an exploitable short-term momentum effect after asset price jumps? In his January 2017 paper entitled “Profitability of Trading in the Direction of Asset Price Jumps – Analysis of Multiple Assets and Frequencies”, Milan Ficura tests the profitability of trading based on continuation of jumps up or down in the price series of each of four currency exchange rates (EUR/USD, GBP/USD, USD/CHF and USD/JPY) and three futures (Light Crude Oil, E-Mini S&P 500 and VIX futures). For each series, he looks for jumps in prices measured at seven intervals (1-minute, 5-minute, 15-minute, 30-minute, 1-hour, 4-hour and 1-day). His statistical specification for jumps uses returns normalized by local historical volatility. He separately tests the last 4, 8, 16, 32, 64, 128 or 256 measurement intervals for the local volatility calculation, and he considers jump identification confidence levels of 90%, 95%, 99% or 99.9%. His trading system enters a trade in the direction of a price jump at the end of the interval in which the jump occurs and holds for a fixed number of intervals (1, 2, 4, 8 or 16). He thus considers a total of 6,860 strategy variations across asset price series. He divides each price series into halves, employing the first half to optimize number of volatility calculation measurement intervals, confidence level and number of holding intervals for each measurement frequency. He then tests the optimal parameters in the second half. He assumes trading frictions of one pip for currencies, and one tick plus broker commission for futures. He focuses on drawdown ratio (average annual profit divided by maximum drawdown) as the key performance metric. He excludes price gaps over weekends and for rolling futures contracts. Using currency exchange rate data during November 1999 through mid-June 2015, Light Crude Oil futures data during January 1987 through early December 2015, E-Mini S&P 500 futures during mid-September 1999 through early December 2015 and VIX futures during late March 2004 through early December 2015, he finds that: Keep Reading

Currency Carry Trade Drawdowns

How frequent, deep and long are currency carry trade (buying currencies with high interest rates and selling currencies with low interest rates) drawdowns, and how can traders mitigate them? In their January 2017 paper entitled “When Carry Goes Bad: The Magnitude, Causes, and Duration of Currency Carry Unwinds”, Michael Melvin and Duncan Shand analyze the worst currency carry trade peak-to-trough drawdowns in recent decades. They hypothesize that three variables affect drawdown duration: (1) financial market stress, as measured by a combination of seven financial variables; (2) carry opportunity, as measured by average interest rate of long currencies minus the average interest rate of short currencies; and, (3) a measure of spot exchange rate valuations based on purchasing power parities. Their carry trade strategy at the end of each month buys (sells) the three one-month forward currency contracts with the highest (lowest) interest rates and closes the contracts in the spot market at the end of the next month. They apply the strategy to developed markets, emerging markets and all currencies. For comparability, they scale each portfolio after the fact to 10% annualized return volatility over the sample period. They examine the ten deepest drawdowns for each portfolio. They investigate drawdown causes and mitigations using the 54 (49) deepest volatility-scaled drawdowns for developed (emerging) markets, corresponding to a cutoff of -1.5% drawdown. Using daily spot and one-month forward exchange rates with the U.S. dollar and monthly interest rates for nine developed market currencies since December 1983 and 20 emerging market currencies since February 1997, all through August 2013, they find that: Keep Reading

Dollar-Euro Exchange Rate, U.S. Stocks and Gold

Do changes in the dollar-euro exchange rate reliably interact with the U.S. stock market and gold? For example, do declines in the dollar relative to the euro indicate increases in the dollar value of hard assets? Are the interactions coincident or exploitably predictive? To investigate, we relate changes in the dollar-euro exchange rate to returns for U.S. stock indexes and spot gold. Using end-of-month and end-of-week values of the dollar-euro exchange rate, levels of the S&P 500 Index and Russell 2000 Index and spot prices for gold during January 1999 (limited by the exchange rate series) through October 2016, we find that: Keep Reading

Bitcoin Return Distribution

Bitcoin is a currency based on cryptographic proof rather than traditional trust, with transactions taking place directly between users and recorded in a distributed public ledger. How wild is the exchange rate for this new form of currency? In their November 2016 paper entitled “A Statistical Risk Assessment of Bitcoin and Its Extreme Tail Behaviour”, Joerg Osterrieder and Julian Lorenz examine the recent distribution of daily Bitcoin-U.S. dollar exchange rate returns, with focus on tail risk metrics. They also compare Bitcoin exchange rate return statistics to those for G10 currencies versus the U.S. dollar. Using daily Bitcoin Baverage and G10 currency exchange rates relative to the U.S. dollar during September 2013 through September 2016, they find that: Keep Reading

Equity+Currency Factors and Global Equity Fund Performance

Do global equity funds generate alpha after accounting for both equity and currency factors? In their October 2016 paper entitled “Global Equity Fund Performance Evaluation with Equity and Currency Style Factors”, David Gallagher, Graham Harman, Camille Schmidt and Geoff Warren measure the performance of global equity funds based on their quarterly holdings after adjusting for market return, six widely used equity factor returns and three widely used currency exchange factor returns. The six equity factors are size (market capitalization), value (average of book-to-market and cash flow-to-price ratios), momentum (return from 12 months ago to one month ago in local currency), investment (quarterly change in total assets), profitability (return-on-equity) and illiquidity (impact of trading). The three currency exchange factors are trend (3-month average exchange rate minus 12-month average exchange rate), carry (reflecting short-term interest rate differences) and value (based on deviation from purchasing power parity). They also test developed and emerging markets holdings of these funds separately. Using quarterly stock holding weights for 90 institutional global equity funds priced in U.S. dollars, and contemporaneous equity and currency exchange factor return data, during 2002 through 2012, they find that: Keep Reading

Long-term Tests of Intrinsic Momentum Across Asset Classes

Does time series (intrinsic or absolute) momentum work across asset classes prior to the Great Moderation (secular decline in interest rates)? In their August 2016 paper entitled “Trend Following: Equity and Bond Crisis Alpha”, Carl Hamill, Sandy Rattray and Otto Van Hemert test several time series momentum portfolios as applied to groups of bonds, commodities, currencies and equity indexes as far back as 1960. They consider 10 developed country equity indexes, 11 developed country government bond series, 25 agricultural/energy/metal futures series and nine U.S. dollar currency exchange rate series. They calculate return momentum for each asset as the weighted sum of its past monthly returns (up to 11 months) divided by the normalized standard deviation of those monthly returns. They then divide each signal again by volatility and apply a gearing factor to specify a 10% annual volatility target for each holding. Within each of equity index, bond and currency groups, they weight components equally. Within commodities, they weight agriculture, energy and metal sectors equally after weighting individual commodities equally within each sector. They report strategy performance based on excess return, roughly equal to real (inflation-adjusted) return. They commence strategy performance analyses in 1960 to include an extreme bond bear market. Using monthly price series that dovetail futures/forwards from inception with preceding spot (cash) data as available starting as early as January 1950 and as late as April 1990, all through 2015, they find that: Keep Reading

Globalization Effects on Asset Return Comovement

Is global diversification within asset classes disappearing as worldwide economic and financial integration increases? In their August 2016 paper entitled “Globalization and Asset Returns”, Geert Bekaert, Campbell Harvey, Andrea Kiguel and Xiaozheng Wang examine whether economic and financial integration increases global comovement of country equity, bond and currency exchange market returns. They examine three measures of return comovement for each asset class: average pairwise correlation, average beta relative to the world market and average idiosyncratic volatility. They apply these measures separately to developed markets and emerging markets. Using monthly equity, bond and currency exchange market returns in U.S. dollars for 26 developed markets and 32 emerging markets as available from various inceptions through December 2014, they find that: Keep Reading

Experiences of Retail Currency Traders

How do individual currency traders view their trading experience? In his June 2016 paper entitled “Retail FX Trader Survey Results”, Chris Davison reports results of an anonymous survey of retail currency traders asking 14 questions about the way they trade. He elicited participants via posts on two online currency trading forums: Forex Factory and MyFXbook. Using responses from 133 traders during late November 2015 through late April 2016, he finds that: Keep Reading

Updated Comprehensive, Long-term Test of Technical Currency Trading

How well does technical trading work for spot currency exchange rates? In their April 2016 paper entitled “Technical Trading: Is it Still Beating the Foreign Exchange Market?”, Po-Hsuan Hsu, Mark Taylor and Zigan Wang test the effectiveness of a broad set of quantitative technical trading rules as applied to exchange rates of 30 currencies with the U.S. dollar over extended periods. They consider 21,195 distinct technical trading rules: 2,835 filter rules; 12,870 moving average rules; 1,890 support-resistance signals; 3,000 channel breakout rules; and, 600 oscillator rules. They employ a test methodology designed to account for data snooping in identifying reliably profitable trading rules. They focus on average return and Sharpe ratio for measuring rule effectiveness. They use empirical bid-ask spread data as available to estimate costs (averaging 0.045% one way for developed markets and 0.21% one way for emerging markets). They also test whether technical trading effectiveness weakens over time. Using daily U.S. dollar spot exchange rates and associated bid-ask spreads as available for nine developed market currencies and 21 emerging market currencies during January 1971 through mid-September 2015, they find that: Keep Reading

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