Initially discovered in equity markets, momentum strategy is a well-known, well-researched, and, most importantly, a robust anomaly. Moreover, it has been documented in various asset classes across the world and by many academics and is considered as a powerful anomaly. Momentum is a trend-following strategy, where the strategy buys the assets which have performed well in the past and sells the assets which have performed bad. No surprise, the momentum anomaly is present also in the currencies. In the currency market, momentum is a widely observed feature that many exchange rates trend on a multi-year basis. Therefore, a strategy that follows the trend typically makes positive returns over time.
The financial literature about the anomaly is consistent, and the academics agree that the momentum anomaly has its place in the FX market, for example, Menkhoff, Sarno, Schmeling, and Schrimpf in the Currency Momentum Strategies, tested the momentum strategy during the period from 1976 to 2010, with an investment universe consisting of more than 40 currencies. They have found a large and significant cross-sectional spread in excess returns of up to 10% p.a. between a past winner and past loser currencies, i.e., currencies with recent high returns continue to outperform currencies with recent low returns by a significant margin.
Interestingly, Grobys and Heinonen have even found that there is 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). They have found that the spread of the zero-cost momentum strategy is significantly larger in high RD states (worldwide crisis state) compared to low RD states.
The primary reason why does the momentum anomaly work is simple; academics explain this anomaly by the irrationality of investors. More precisely, their underreaction to the new information, failing to incorporate news in the prices. Menkhoff, Sarno, Schmeling, and Schrimpf add: “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.”
Another possible explanation is that momentum investors are exploiting behavioral shortcomings in other investors, such as investor herding, investor over- and under-reaction, and confirmation bias. Concentrating on the FX momentum, the segmentation of the currency market where some participants act quickly on the news while others respond more slowly is one reason why trends emerge and can be protracted. Additionally, Bae and Elkamhi in “Global Equity Correlation in Carry and Momentum Trades” have provided a risk-based explanation for the excess returns of two widely-known currency speculation strategies: carry and momentum trades. They have constructed a global equity correlation factor and showed that it explains the variation in average excess returns of both these strategies, where the global correlation factor has a robust negative price of beta risk in the FX market. Moreover, Filippou, Gozluklu, and Taylor have shown that the global political environment affects all currencies and 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.
OOS back-test shows slightly negative performance. It looks, that strategy’s alpha is deteriorating in the out-of-sample period.
per annum, performance is calculated from Deutsche Bank Currency Momentum USD Index
volatility is calculated from Deutsche Bank Currency Momentum USD Index
it depends on investor’s need for diversification (10-20)
Create an investment universe consisting of several currencies (10-20). Go long three currencies with the highest 12-month momentum against USD and go short three currencies with the lowest 12-month momentum against USD. Cash not used as margin invest on overnight rates. Rebalance monthly.
Yes - Currency investment styles (factors) like momentum and value have a low correlation to traditional equity market factor. FX momentum can be profitably used to augment conventional equity-heavy asset allocation, we recommend to check research paper by Lohre and Kolrep: “Currency Management with Style” as an example. Also, a paper by Grobys, Heinonen, and Kolari shows that the FX momentum factor is a hedge for global economic risk in their research paper “Is Currency Momentum a Hedge for Global Economic Risk?”.
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