New related paper to #5 – FX Carry Trade and #8 – FX Momentum

"What makes a momentum strategy profitable? Its profitability relies on the existence of sustainable price trends. If the price of a market has been rising, a momentum strategy expects that prices will continue to rise, and if prices have been falling, that they will continue to fall. This assumption is contrary to most traditional economic theories that assume that all agents in the economy have perfect information and that the current price reflects all known information. Under these and other unrealistic assumptions, asset prices should be unpredictable based on past prices, thus rendering a momentum strategy (and any other strategy that uses only past prices) theoretically useless. However, in the real world, it is clear that no one has perfect information, and rarely does everyone have the same information at the same time. Even if some traders have the same information at the same time, they will likely interpret and react differently according to their own preferences, expertise and circumstances. As summarized by Brunnermeier (2001), there are now quite a few theoretical studies that support the value of a momentum strategy based on the asymmetric information structure in the economy. Evidence suggests that a market can be efficient or in a rational equilibrium even if its prices follow predictable trends. Recently, Cespa and Vives (2012) show further that the presence of liquidity traders and asset payoff uncertainty will generate rational trends in a market. Intuitively, hedging demand also takes time to fulfill in the market. The greater the risk to be hedged the greater the demand, and thus the greater the persistence of a price trend. In addition, the build-up of large investment or speculative positions also results in large liquidity demands and promotes the presence of price trends. Recently, Zhou and Zhu (2013) show that not only does trend-following exist in rational equilibrium, but it can also forecast the market returns. From a behavioral finance point of view, the rationale for price trends is even simpler. Investors or traders may initially under-react to news that leads to under-valuation of an asset. Subsequently, as the price goes up, the fundamental value will eventually be realized. However, as the price is going up, traders become over-confident and over-react to news, leading to an over-valuation of the asset and further strengthening of the trend until an inevitable price reversal occurs."

"What are the advantages and disadvantages of a macro/fundamental strategy such as FX carry? Ultimately, prices are determined by factors affecting the fundamentals of supply and demand. Unlike a momentum strategy that waits for changes in price to determine position changes, a macro/fundamental strategy such as FX carry can change positions immediately upon changes in fundamentals. However, such strategies are not without limitations. Since they are based on factors other than the price of the market being traded, their greatest weakness is that they can get out of sync with the market for long periods of time. As economic conditions change, factors that are viewed as important by market participants will often come in and out of vogue. For example, during some market cycles weak commodity prices may be viewed as a positive for equity prices whereas in other cycles they are viewed as negative. Because of this, even the most effective macro/fundamental strategy requires constant monitoring to ensure that the selected factor is still relevant."

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