Currency Value Factor – PPP Strategy

There are several features of currency returns that make currency an attractive asset class for institutional investors. Still, 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 an FX value, deeply connected with a Purchasing power parity (PPP), a theory concerning the long-term equilibrium exchange rates based on a relative price level of two countries. The concept mentioned above was founded on the law of one price – the idea that in the 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 critical factors, as well as FX momentum or FX carry.

Fundamental reason

Menkhoff, Sarno, Schmeling, and Schrimpf in “Currency Value” have shown 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 mentioned above stem from persistent cross-country differences in macroeconomic fundamentals. This suggests that currency value mostly captures risk premia, which vary across countries but are relatively 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 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 very slowly over time. A rebalanced portfolio, which has the most undervalued and overvalued currencies, helps to capture gains from the exchange rate convergence to the fair value.

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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
7.8%

Period of Rebalancing
Quarterly

Notes to Indicative Performance

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


Notes to Period of Rebalancing

Estimated Volatility
9.06%

Number of Traded Instruments
10

Notes to Estimated Volatility

volatility is calculated from Deutsche Bank Currency Valuation USD Index


Notes to Number of Traded Instruments

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


Maximum Drawdown
-17.88%

Complexity Evaluation
Simple strategy

Notes to Maximum drawdown

Notes to Complexity Evaluation

Sharpe Ratio
0.86

Simple trading strategy

Create an investment universe consisting of several currencies (10-20). Use the latest OECD Purchasing Power Parity figure to assess the 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 three currencies that are the most undervalued (lowest PPP fair value figure) and go short three currencies that are the most overvalued (highest PPP fair value figure). Invest cash not used as margin on overnight rates. Rebalance quarterly or 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 value 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. FX Value correlation to equities often goes into negative territory in a time of stress (as this is usually a time when undervalued currencies appreciate and overvalued strongly depreciate), and this feature makes this style a very valuable hedge.

Source paper
Strategy's implementation in QuantConnect's framework (chart+statistics+code)
Other papers

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