International Finance: Currency Momentum Strategies - Essay Example

? International Finance: Currency Momentum Strategies October 08 Introduction This paper analyses an article on foreign currency FX momentumstrategies written by Menkhoff et al (2011) who have studied the currency movements and trends for 48 currencies1. The price momentums are studied from the years 1976 to 2010 and the results calculated using econometric methods. The rest of the paper is as follows. First, it provides a summary of the article by Menkhoff et al. Next section is an appraisal and critique of this article followed by a conclusion. 2. Summary of the article Using time series data of more than 34 years, the paper has examined some important aspects of FX momentum. The article provides an in-depth analysis of the unsystematic and systematic risks, comparing different momentum strategies, describing the importance of transaction costs, sources for non-standard momentum, over and under reaction and the arbitrage limits. The paper has also researched in effect of business cycle risks on currency momentum. 2.1. Fundamentals According to Menkhoff et al (2011, p. 5-8), momentum strategy refers to the trading strategy where an investor seizes an opportunity to ride a rising or a falling trend of the currency market. The basic idea is that an investor will take a long position for a basket of currency that shows an increasing trending price or a short position that sees a decreasing price. Momentum trading is done with the belief that once a trend is established, it will continue in the same direction for some time before stabilising and then reducing. If one sells when the prices are showing a decreasing trend, then the trader is taking a short position and he wants to reduce the losses and exit the currency before it reaches the bottom. If the trader buys when the price is showing a rising trend, then he is taking a long position and by buying when the trend is rising, the investor can hope to make more profits since he hopes the price will continue to rise. In both cases of long and short position, there is an upward and a downward momentum. This principle holds true for the all types of trading markets such as stocks, bonds, property, commodity, bullion and other markets that sees volatility in the markets and traders make profits on an hourly basis by seizing and riding the opportunity trend (Menkhoff et al, 2011, p. 8). 2.2. Data and Portfolio formation While earlier studies have focussed on single time series currency, the research by Menkhoff et al (2011, p. 9-12) uses cross sectional currency. This means the relations and momentums of 48 different currencies are considered. By considering a period of 34 years, one can see a better return variation over time for the currencies. This also allows better accounting for transaction cists and helps to understand the limits of arbitrage. Data were obtained from databases of Reuters and BBI for the spot and forward rates for end of month data. Total observations made were 9,043. 2.3. FX momentum Strategies Different test strategies were selected for the study. These are features currency momentum strategies, stability of strategies for out of sample tests, differences in trading rules, carry trades and currency momentum and long-term behaviour (Menkhoff, et al, 2011, p. 14-15). The strategies as reported by Menkhoff et al (2011, p. 15-26) showed different test behaviour, Momentum strategies provide high returns of 6-10% for holding durations of a month and then they reduce when the holding period is increased and profitability comes from spot rate changes. By using different cross section of currencies, it is seen that gain decrease when a large cross section of currencies is selected. The authors run the tests to compare momentum of trading rules where three-benchmark averages cross over rules were used. These strategies showed profits of more than 5% with high annual Sharpe Ratios, however, there were variations in the returns. Hence, the relation of currency momentum to benchmark technical trading strategies is not close. It was also clear that momentum strategies and carry portfolios are not identical but have differences in return correlations and in situations where the discounts are lagged. Slow information diffusion influences momentum returns, and this produces under reaction and persistence in returns. This currency momentum is similar to stock trading momentum and investor drives the returns over reaction. 2.4. Results observed and checks taken Results of the tests indicate some important behaviour (Menkhoff, et al, 2011, p. 27-39). Transaction costs reduce returns from 10% to 4%, thus, wiping out al gains. Results also showed that standard business cycle variables and portfolio-based risk factors do not appear to be related to currency momentums. For investors seeking arbitrage, the results favour better returns for investors with long-term vision and not for short-term gains. Momentum returns are high for currencies with high idiosyncratic volatility and risk. Arbitrage risks are higher for nations with greater political and financial instability and risks. 2.5. Conclusions drawn Based on the findings, it can be concluded that momentum strategies that rely on winners and losers show unconditional average excess returns of 10% per annum. The performance is subjected to overreaction for long-term horizons and the performance is similar to that of equity markets. Momentum returns are different from standard trading rules. Results are skewed towards minor currencies with higher transaction costs and these costs consume 50% of returns. One usually does not take up short selling, and sellers are institution sellers and big brokers. Changes in monetary regimes, currency intervention and capital account controls do not influence currency momentums. 3. Critical appraisal of the article The article by Menkhoff et al (2011) is highly structured, methodical and demonstrates the thoroughness of the research. However, I, the author of this paper, raise some serious doubts and misgivings as follows. Duration of the paper is from 1976 to 2010, and the authors consider many European nations in the sample. The problem is that other than the UK, many of these nations switched off to Euro and so from 2000 onwards, nations such as Germany, Slovakia, Greece and others do not have their own currency. The Euro is not mentioned in the portfolio and one wonders from where the respected authors have obtained currency fluctuations and spot rates. An attempt has been made at oversimplification in the results when the learned authors Menkhoff et al (2011) say that returns of an average 10% are obtained when trading is done as per currency momentums. As stated by the authors and seen in ‘section 2.2’, data are gathered for spot rates of end of month. What is also very surprising in the findings is that changes in currency valuations and changes in monetary regimes, currency intervention and capital account controls do not affect the momentum trends. This becomes hard to believe as, for example, Japan saw an overnight change in the Yens performance versus the dollar after the earthquake and tsunami. Consider the following figure that compares the performance of Yen, USD with indices of Dow, NASDAQ and S&P 500: Figure 1. Yen vs. USD and comparison with Dow, NASDAQ and S&P 500 (Performance of USD versus Yen, 2012) On 13 Jan 2011, the Yen was trading at 83 to the USD and on 15 August, it was trading at 78 USD. This gives a shortfall or loss of 6% while Menkhoff et al (2011) indicate a loss or gain of 10%. The results of the learned authors may hold true for the whole data set and for 34 years but they may not hold true for individual currencies. In addition, the authors have suggested that momentum returns are independent of changes in policy and fiscal measures that government may bring in to control inflation. As seen in the above graph, the Yen vs. USD plot follows the movement of the three indices, though the values and changes may be much lower. One point noticed is that the article argues that momentum investing believes in ‘investing in winners and moving away from losers’. There is nothing new in this process and almost any investor who wants to invest just when the prices begin to rise and to book the profits when the price nears the peak uses this method. The problem is to identify a pattern for the rise and fall duration in order to estimate a holding duration. Since the authors have not provided the datasets used in the research, it is not possible to understand the investment and holding horizon. At one point, a period of one month is regarded as a safe holding period; later, this period is vaguely mentioned. Thus, the article while it is well researched proves to be an academic artefact that shows how good research must be conducted and how articles should be written. The document does not afford any guidance for a person interested to invest and play the currency market. 4. Conclusion This report has analysed the article on currency momentum strategies. According to the findings, by using the optimum strategy, it is possible to obtain a return of 10% per annum on an average. However, with the actual data from the market, there was some mismatch between the findings and the market behaviour. References Menkhoff, L., Sarno, L., & Schrimpf, A., 2011. Currency Momentum Strategies: BIS Working Papers No 366. [Online] Available at http://www.bis.org/publ/work366.pdf [Accessed 8 October 2012] Performance of USD versus Yen. Yahoo. [Online] Available at http://in.finance.yahoo.com/q?s=USDJPY=X [Accessed 8 October 2012] Read More