FX Momentum

Momentum strategy is a very well known and robust anomaly and has been documented in several different assets across the world. It was originally discovered in equity markets, but momentum has strong results also in currencies. It is probably the most investigated anomaly and financial academics consider it as the one of the strongest.

Fundamental reason

Momentum is most often explained by investors irrationality - their underreaction to new information by failing to incorporate news in their transaction prices. Another explanation is that momentum investors are exploiting behavioral shortcomings in other investors, such as investor herding, investor over- and under-reaction and confirmation bias.

Markets traded
Confidence in anomaly's validity
Notes to Confidence in anomaly's validity
Period of rebalancing
Notes to Period of rebalancing
Number of traded instruments
Notes to Number of traded instruments
it depends on investor's need for diversification (10-20)
Complexity evaluation
Simple strategy
Notes to Complexity evaluation
Financial instruments
futures, forwards, swaps, CFDs
Backtest period from source paper
Indicative performance
Notes to Indicative performance
per annum, performance is calculated from Deutsche Bank Currency Momentum USD Index
Estimated volatility
Notes to Estimated volatility
volatility is calculated from Deutsche Bank Currency Momentum USD Index
Maximum drawdown
Notes to Maximum drawdown
Sharpe Ratio


momentum, FX anomaly, forex system

Simple trading strategy

Create an investment universe consisting of several currencies (10-20). Go long 3 currencies with strongest 12 month momentum against USD and go short 3 currencies with lowest 12 month momentum against USD. Cash not used as margin invest on overnight rates. Rebalance monthly.

Source Paper

Deutsche Bank
Momentum - A widely observed feature of currency markets is that many Exchange rates trend on a multi-year basis. Therefore a strategy that follows the trend typically makes positive returns over time. The segmentation of currency market participants with some acting quickly on news while others respond more sowy is one reason why trends emerge and can be protracted

Other Papers

Menkhoff, Sarno, Schmeling, Schrimpf: Currency Momentum Strategies
We provide a comprehensive empirical investigation of momentum strategies in foreign exchange markets which covers the period from 1976 to 2010 and more than 40 currencies. We find a large and significant cross-sectional spread in excess returns of up to 10% p.a. between past winner and past loser currencies, i.e. currencies with high recent returns continue to outperform currencies with low recent returns by a significant margin. Similar to momentum in equity markets, this spread in excess returns is not explained by traditional risk factors and shows behavior consistent with investor over- and underreaction. Moreover, currency momentum is mostly driven by return continuation in spot rates (and not interest rate differentials) and has very different properties from the widely studied carry trade. However, there seem to be effective limits to arbitrage which prevent momentum returns from being exploitable in foreign exchange markets. Momentum portfolios incur large transaction costs and are heavily skewed towards currencies with high idiosyncratic volatility and high country risk.

Bianchi, Drew, Polichronis: A Test of Momentum Trading Strategies in Foreign Exchange Markets: Evidence from the G7
In this trading strategy study, we ask three questions. First, does momentum exist in foreign exchange markets? Second, what is the impact of transactions costs on excess returns? And, third, can a consolidated trading signal garner excess returns and, if so, what is the source of such returns? Using total return momentum strategies in the foreign exchange markets of the G7 for the period 1980 through 2004, the answers from this study are as follows: we find evidence of momentum; however, such momentum appears transitory, particularly for longer look back periods. As expected, transaction costs have a material negative impact on excess returns. Finally, a consolidated signal garners excess returns; however, a bootstrap simulation finds the source of these returns is a function of autocorrelation.

Kroencke, Schindler, Schrimpf: International Diversification Benefits with Foreign Exchange Investment Styles
Style-based investments and their role for portfolio allocation have been widely studied by researchers in stock markets. By contrast, there exists considerably less knowledge about the portfolio implications of style investing in foreign exchange markets. Indeed, style-based investing in foreign exchange markets is nowadays very popular and arguably accounts for a considerable fraction in trading volumes in foreign exchange markets. This study aims at providing a better understanding of the characteristics and behavior of stylebased foreign exchange investments in a portfolio context. We provide a comprehensive treatment of the most popular foreign exchange investment styles over the period from January 1985 to December 2009. We go beyond the well known carry trade strategy and investigate further foreign exchange investment styles, namely foreign exchange momentum strategies and foreign exchange value strategies. We use traditional mean-variance spanning tests and recently proposed multivariate stochastic dominance tests to assess portfolio investment opportunities from foreign exchange investment styles. We nd statistically signi cant and economically meaningful improvements through style-based foreign exchange investments. An internationally oriented stock portfolio augmented with foreign exchange investment styles generates up to 30% higher return per unit of risk within the covered sample period. The documented diversi cation bene ts broadly prevail after accounting for transaction costs due to rebalancing of the style-based portfolios, and also hold when portfolio allocation is assessed in an out-of-sample framework.

Amen: Beta'em Up: What is Market Beta in FX?
In asset classes such as equities, the market beta is fairly clear. However, this question is more difficult to answer within FX, where there is no obvious beta. To help answer the question, we discuss generic FX styles that can be used as a proxy for the returns of a typical FX investor. We also look at the properties of a portfolio of these generic styles. This FX styles portfolio has an information ratio of 0.64 since 1976. Unlike its individual components, the FX styles portfolio returns are relatively stable with respect to underlying regimes in S&P500. Later we replicate FX fund returns using a combination of these generic FX styles. We show that a combination of FX trend and carry, can be used as a beta for the FX market. Later, we examine the relationship between bank indices and these generic FX styles. We find that there is a significant correlation in most instances, with some exceptions.

Accominotti, Chambers: Out-of-Sample Evidence on the Returns to Currency Trading
We document the existence of excess returns to naïve currency trading strategies during the emergence of the modern foreign exchange market in the 1920s and 1930s. This era of active currency speculation constitutes a natural out-of-sample test of the performance of carry, momentum and value strategies well documented in the modern era. We find that the positive carry and momentum returns in currencies over the last thirty years are also present in this earlier period. In contrast, the returns to a simple value strategy are negative. In addition, we benchmark the rules-based carry and momentum strategies against the discretionary strategy of an informed currency trader: John Maynard Keynes. The fact that the strategies outperformed a superior trader such as Keynes underscores the outsized nature of their returns. Our findings are robust to controlling for transaction costs and, similar to today, are in part explained by the limits to arbitrage experienced by contemporary currency traders.

Orlov: Currency Momentum, Carry Trade and Market Illiquidity
This study empirically examines the effect of equity market illiquidity on the excess returns of currency momentum and carry trade strategies. Results uniformly show that equity market illiquidity explains the evolution of strategy payoffs, consistent with a liquidity-based model. Comprehensive experiments, using both time-series and cross-sectional specifications, show that returns on the strategies are low (high) following months of high (low) equity market illiquidity. This effect is found to withstand various robustness checks and is economically significant, approximating in value to one-third of average monthly profits.

Bae, Elkamhi: Global Equity Correlation in Carry and Momentum Trades
We provide a risk-based explanation for the excess returns of two widely-known currency speculation strategies: carry and momentum trades. We construct a global equity correlation factor and show that it explains the variation in average excess returns of both these strategies. The global correlation factor has a robust negative price of beta risk in the FX market. We also present a multi-currency model which illustrates why heterogeneous exposures to our correlation factor explain the excess returns of both portfolios.

Filippou, Gozluklu, Taylor: Global Political Risk and Currency Momentum
This paper investigates the role of political risk in the currency market. We propose a measure of global political risk relative to U.S. that captures unexpected political conditions. Global political risk is priced in the cross-section of currency momentum and it 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 all currencies; investors following momentum strategies are compensated for the exposure to the global political risk of those currencies they hold, i.e., the past winners, while past losers provide a natural hedge.

Pojarliev, Levich: A New Look at Currency Investing
The authors of this book examine the rationale for investing in currency. They highlight several features of currency returns that make currency an attractive asset class for institutional investors. Using style factors to model currency returns provides a natural way to decompose returns into alpha and beta components. They find that several established currency trading strategies (variants of carry, trend-following, and value strategies) produce consistent returns that can be proxied as style or risk factors and have the nature of beta returns. Then, using two datasets of returns of actual currency hedge funds, they find that some currency managers produce true alpha. Finally, they find that adding to an institutional investor’s portfolio even a small amount of currency exposure — particularly to alpha generators — can make a meaningful positive impact on the portfolio’s performance.

Olszweski, Zhou: Strategy diversification: Combining momentum and carry strategies within a foreign exchange portfolio
Hedge funds, such as managed futures, typically use two different types of trading strategies: technical and macro/fundamental. In this article, we evaluate the impact of combining the two strategies, and focus on, in particular, two common foreign exchangetrading strategies: momentum and carry. We find evidence that combining the strategies offers a significant improvement in risk-adjusted returns. Our analysis, which uses data spanning 20 years, highlights the potential benefits of achieving strategy-level diversification.

Geczy, Samonov: 215 Years of Global Multi-Asset Momentum: 1800-2014 (Equities, Sectors, Currencies, Bonds, Commodities and Stocks)
Extending price return momentum tests to the longest available histories of global financial asset returns, including country-specific sectors and stocks, fixed income, currencies, and commodities, as well as U.S. stocks, we create a 215-year history of multi-asset momentum, and we confirm the significance of the momentum premium inside and across asset classes. Consistent with stock-level results, we document a large variation of momentum portfolio betas, conditional on the direction and duration of the return of the asset class in which the momentum portfolio is built. A significant recent rise in pair-wise momentum portfolio correlations suggests features of the data important for empiricists, theoreticians and practitioners alike.

Goyal, Jegadeesh: Cross-Sectional and Time-Series Tests of Return Predictability: What Is the Difference?
We analyze the differences between past-return based strategies that differ in conditioning on past returns in excess of zero (time-series strategy, TS) and past returns in excess of the cross-sectional average (cross-sectional strategy, CS). We find that the return difference between these two strategies is mainly due to time-varying long positions that the TS strategy takes in the aggregate market and, consequently, do not have any implications for the behavior of individual asset prices. However, TS and CS strategies based on financial ratios as predictors are sometimes different due to asset selection.

Grobys, Heinonen: Is Momentum in Currency Markets Driven by Global Economic Risk?
This article documents a robust link between the returns of the momentum anomaly implemented in currency markets and global economic risk, measured by the currency return dispersion (RD). We find the spread of the zero-cost momentum strategy to be significantly larger in high RD states compared to low RD states. The relation between momentum payoffs and global economic risk appears to increase linearly in risk. Notably, the results provide strong evidence that the same global economic risk component is present in equity markets.

Aloosh, Bekaert: Currency Factors
We examine the ability of existing and new factor models to explain the comovements of G10-currency changes. Extant currency factors include the carry, volatility, value, and momentum factors. Using a new clustering technique, we find a clear two-block structure in currency comovements with the first block containing mostly the dollar currencies, and the other the European currencies. A factor model incorporating this “clustering” factor and two additional factors, a commodity currency factor and a “world” factor based on trading volumes, fits all bilateral exchange rates well, whatever the currency perspective. In particular, it explains on average about 60% of currency variation and generates a root mean squared error relative to sample correlations of only 0.11. The model also explains a considerable fraction of the variation in emerging market currencies.

Eriksen: Cross-Sectional Return Dispersion and Currency Momentum
This paper studies the relation between global foreign exchange (FX) return dispersion risk and the cross-section of currency momentum returns. We find robust empirical evidence that FX return dispersion is a priced risk factor and that it contains information beyond traditional factors. Currencies with high past returns (winners) load positively on dispersion innovations, whereas currencies with low past returns (losers) load negatively. Intuitively, investors demand a premium for holding past winners as they perform poorly in periods with unexpectedly low cross-sectional dispersion, while past losers provide insurance against periods with disappearing dispersion.

Fratzcher, Menkhoff, Sarno, Schmeling, Stoehr: Systematic Intervention and Currency Risk Premia
Using data for the trades of 19 central banks intervening in currency markets, we show that leaning against the wind by individual central banks leads to "systematic intervention" in the aggregate central banking sector. This systematic intervention is driven by and impacts on the same factors that drive currency excess returns: carry, momentum, value, and a dollar factor. The sensitivity of an individual central bank's intervention to these factors differs markedly across countries, with developed countries making a profit from intervention and emerging markets incurring large losses.