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FX Value - PPP Strategy

There are several features of currency returns that make currency an attractive asset class for institutional investors, but the FX market has become popular also in the world of individual investors and therefore it is beneficial to study various factors in this currency world. One of these factors is a FX value, deeply connected with a Purchasing power parity (PPP), a theory concerning the long-term equilibrium exchange rates based on a relative price levels of two countries. The aforementioned concept was founded on the law of one price - the idea that in absence of transaction costs, identical goods in different markets would be priced the same. No surprise, different countries consume different baskets of goods, however, it is partially possible to asses a relative price level, more precisely, it is possible to find out which country is "cheaper" and on the other hand, which country is "more expensive" for living.

PPP theory states, that price differences between countries should narrow over time by the exchange rate movements or by different rates of inflation (which also has some implications on exchange rate movements). Concentrating on the FX market in the long-run, currencies tend to move towards their "fair value". Consequently, systematically buying "undervalued" currencies and selling "overvalued" currencies leads to a profitable trading strategy in the medium-term. Last but not least, the world of academics recognizes the value in the foreign exchange market as one of the key factor, as well as FX momentum or FX carry.

Fundamental reason

Menkhoff, Sarno, Schmeling and Schrimpf in "Currency Value" have showed that measures of currency valuation derived from real exchange rates contain significant predictive content for FX excess returns and spot exchange rate changes in the cross section of currencies. Most of the aforementioned predictability stems from persistent cross-country differences in macroeconomic fundamentals. This suggests that currency value mostly captures risk premia which vary across countries, but are fairly static over time. Moreover, their results do not support the standard notion that trading on simple measures of currency value is profitable because spot exchange rates are reverting back to fundamental values. When the real exchange rates are decomposed into underlying macroeconomic drivers, it was found that refined valuation measures relate more closely to "currency value" in the original sense in that they predict both excess returns as well as a reversal of exchange rates.

Additionally, as it was already mentioned in the description, different countries consume different baskets of goods and it is partially possible to asses the relative price level - to identify which country is "cheap" and which country is "expensive". The price differences between countries narrow just very slowly over time. A rebalanced portfolio, which has the actually most undervalued and overvalued currencies helps to capture gains from the exchange rate convergence to the fair value.

Markets traded
currencies
Confidence in anomaly's validity
Strong
Notes to Confidence in anomaly's validity
Period of rebalancing
Quarterly
Notes to Period of rebalancing
(or Monthly)
Number of traded instruments
10
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
1989-2010
Indicative performance
7.80%
Notes to Indicative performance
per annum, performance is calculated from Deutsche Bank Currency Valuation USD Index
Estimated volatility
9.06%
Notes to Estimated volatility
volatility is calculated from Deutsche Bank Currency Valuation USD Index
Maximum drawdown
-17.88%
Notes to Maximum drawdown
Sharpe Ratio
0.86

Keywords:

value, FX anomaly, forex system

Simple trading strategy

Create an investment universe consisting of several currencies (10-20). Use the latest OECD Purchasing Power Parity figure to assess fair value of each currency versus USD in the month of publishing and then use monthly CPI changes and exchange rate changes to create fair PPP value for the month prior to the current month. Go long 3 currencies which are the most undervalued (lowest PPP fair value figure) and go short 3 currencies which are the most overvalued (highest PPP fair value figure). Invest cash not used as margin on overnight rates. Rebalance quarterly or monthly.

Source Paper

Deutsche Bank
https://index.db.com/htmlPages/DBCR_brochure.pdf
http://quantpedia.com/www/DBCR_Brochure.pdf
Abstract:
Valuation - In the long run, currencies tend to move towards their „fair value“. Consequently, systematically buying „undervalued“ currencies and selling „overvalued“ currencies is profitable in the medium term. One of the strongest conclusions in academia is that fundamentals tend not to work for currencies in the short to medium term, yet they do long term. One of the oldest measures of „fair value“, purchasing power parity, has been shown to work in the long run.

Other Papers

Kroencke, Schindler, Schrimpf: International Diversification Benefits with Foreign Exchange Investment Styles
http://ftp.zew.de/pub/zew-docs/dp/dp11028.pdf
Abstract:
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?
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2439854
Abstract:
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
https://research.mbs.ac.uk/accounting-finance/Portals/0/docs/Out-of-Sample%20Evidence%20on%20the%20Returns.pdf
Abstract:
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.

Menkhoff, Sarno, Schmeling, Schrimpf: Currency Value
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2492082
Abstract:
We show that measures of currency valuation derived from real exchange rates contain significant predictive content for FX excess returns and spot exchange rate changes in the cross section of currencies. Most of the predictability stems from persistent cross-country differences in macroeconomic fundamentals. This suggests that currency value mostly captures risk premia which vary across countries but are fairly static over time. Moreover, our results do not support the standard notion that trading on simple measures of currency value is profitable because spot exchange rates are reverting back to fundamental values. When decomposing real exchange rates into underlying macroeconomic drivers, however, we find that refined valuation measures relate more closely to "currency value" in the original sense in that they predict both excess returns as well as a reversal of exchange rates.

Pojarliev, Levich: A New Look at Currency Investing
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2571391
Abstract:
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.

Aloosh, Bekaert: Currency Factors
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3022623
Abstract:
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.

Fratzcher, Menkhoff, Sarno, Schmeling, Stoehr: Systematic Intervention and Currency Risk Premia
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3119907
Abstract:
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.

Lohre, Kolrep: Currency Management with Style
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3175387
Abstract:
Currency hedging is often approached with an all-or-nothing mentality: either full hedging of all foreign exchange (FX) positions or no hedging at all. As a more nuanced alternative, we suggest systematically harvesting the benefits of the FX style factors carry, value and momentum. In particular, we demonstrate how these factors can expand the opportunity set of traditional asset allocation when pursuing either FX factor-based tail-hedging or return-seeking strategies.

Hypothetical future performance