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 really strong 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.

Fundamental reason

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, resulting in a failure 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.

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Markets Traded
currencies

Financial instruments
CFDs, forwards, futures, swaps

Confidence in anomaly's validity
Strong

Backtest period from source paper
1989-2010

Notes to Confidence in Anomaly's Validity

Indicative Performance
6.48%

Period of Rebalancing
Monthly

Notes to Indicative Performance

per annum, performance is calculated from Deutsche Bank Currency Momentum USD Index


Notes to Period of Rebalancing

Estimated Volatility
10%

Number of Traded Instruments
10

Notes to Estimated Volatility

volatility is calculated from Deutsche Bank Currency Momentum USD Index


Notes to Number of Traded Instruments

it depends on investor’s need for diversification (10-20)


Maximum Drawdown
-21.63%

Complexity Evaluation
Simple strategy

Notes to Maximum drawdown

Notes to Complexity Evaluation

Sharpe Ratio
0.65

Simple trading strategy

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

Hedge for stocks during bear markets

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 traditional equity heavy asset allocation, we recommend to check research paper by Lohre and Kolrep: “Currency Management with Style” as an example. Also, paper by Grobys, Heinonen and Kolari shows that FX momentum factor is a hedge for global economic risk in their research paper “Is Currency Momentum a Hedge for Global Economic Risk?”.

Source paper
Deutsche Bank
- Abstract

http://quantpedia.com/www/DBCR_Brochure.pdf

Abstract:

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

Strategy's implementation in QuantConnect's framework (chart+statistics+code)
Other papers
Menkhoff, Sarno, Schmeling, Schrimpf: Currency Momentum Strategies
- Abstract

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
- Abstract

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
- 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 diversification 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?
- 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
- 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.

Orlov: Currency Momentum, Carry Trade and Market Illiquidity
- Abstract

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
- Abstract

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
- Abstract

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
- 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.

Olszweski, Zhou: Strategy diversification: Combining momentum and carry strategies within a foreign exchange portfolio
- Abstract

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)
- Abstract

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?
- Abstract

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?
- Abstract

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
- 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.

Eriksen: Cross-Sectional Return Dispersion and Currency Momentum
- Abstract

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
- 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
- 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.

Amen: Beta’em Up: What is Market Beta in FX?
- 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.

Jiang: US Fiscal Cycle and the Dollar
- Abstract

When the US fiscal condition is strong, the dollar is strong and continues to appreciate against foreign currencies in the next 3 years. This pattern is unique to the US, explaining 50% of the low-frequency variation in the dollar’s value and absorbing the return predictability of the forward premium. In a model with sticky prices, I show this pattern is driven by the comovement between the US fiscal cycle and the US investors’ risk appetite: During US expansions, higher US government surpluses increase the nominal value of the dollar, while less risk-averse US investors require lower returns to hold foreign currencies. Consistent with this view, the US fiscal cycle also explains the term premium, the dollar carry trade, the currency return momentum, and the US investors’ capital flows.

Ilmanen, Israel, Moskowitz, Thapar, Wang: Factor Premia and Factor Timing: A Century of Evidence
- Abstract

We examine four prominent factor premia – value, momentum, carry, and defensive – over a century from six asset classes. First, we verify their existence with a mass of out-of-sample evidence across time and asset markets. We find a 30% drop in estimated premia out of sample, which we show is more likely due to overfitting than informed trading. Second, probing for potential underlying sources of the premia, we find little reliable relation to macroeconomic risks, liquidity, sentiment, or crash risks, despite adding five decades of global economic events. Finally, we find significant time-variation in factor premia that are mildly predictable when imposing theoretical restrictions on timing models. However, significant profitability eludes a host of timing strategies once proper data lags and transactions costs are accounted for. The results offer support for time-varying risk premia models with important implications for theory seeking to explain the sources of factor returns.

Baku, Fortes, Herve, Lezmi, Malongo, Roncalli, Xu: Factor Investing in Currency Markets: Does it Make Sense?
- Abstract

The concept of factor investing emerged at the end of the 2000s and has completely changed the landscape of equity investing. Today, institutional investors structure their strategic asset allocation around five risk factors: size, value, low beta, momentum and quality. This approach has been extended to multi-asset portfolios and is known as the alternative risk premia model. This framework recognizes that the construction of diversified portfolios cannot only be reduced to the allocation policy between asset classes, such as stocks and bonds. Indeed, diversification is multifaceted and must also consider alternative risk factors. More recently, factor investing has gained popularity in the fixed income universe, even though the use of risk factors is an old topic for modeling the yield curve and pricing interest rate contingent claims. Factor investing is now implemented for managing portfolios of corporate bonds or emerging bonds.

In this paper, we focus on currency markets. The dynamics of foreign exchange rates are generally explained by several theoretical economic models that are commonly presented as competing approaches. In our opinion, they are more complementary and they can be the backbone of a Fama-French-Carhart risk factor model for currencies. In particular, we show that these risk factors

may explain a significant part of time-series and cross-section returns in foreign exchange markets. Therefore, this result helps us to better understand the management of forex portfolios. To illustrate this point, we provide some applications concerning basket hedging, overlay management and the construction of alpha strategies.

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