FX anomaly

The market of every asset class has anomalies, which you can turn into profit if you know how to use them. Most of the anomalies are the same (with specific differences attributable to the asset class) across asset classes, and the foreign exchange market is no exception. However, academic research on foreign exchange market anomalies is not so extensive as on equities (which are historically much more popular). Despite this fact, there are well-documented anomalies in the foreign exchange market as momentum, carry, value, volatility and many more with considerable performance.

These strategies can be focused only on one currency with one anomaly implementation, which fits the currency the most, or they can be implemented in a broad investment universe.

As an example of FX anomaly, we can mention the strategy, which is probably the most well-known – FX Carry Trade. The idea of the carry trade strategy is really simple, strategy systematically sells low-interest-rates currencies and buys high-interest rates currencies trying to capture the spread between the rates. Moreover, considering a longer time frame, there is a low correlation between the returns of employing the carry strategy and the returns which could be gained from investing in more traditional asset classes. That makes a carry strategy an interesting way of how to diversify a portfolio. However, the investor must pay attention to the carry trade strategy’s correlation with global financial stability and exchange rate stability.

For the second example, we chose a strategy based on Currency value factor that is deeply connected with Purchasing power parity (theory concerning the long-term equilibrium exchange rates based on a relative price level of two countries). 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.

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    The Encyclopedia of Quantitative Trading Strategies

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