Forex system

Momentum In International Government Bonds Can Be Explained By Currency Momentum

18.April 2019

A new academic paper related to:

#8 – Currency Momentum Factor

Authors: Zaremba, Kambouris

Title: The Sources of Momentum in International Government Bond Returns

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3332942

Abstract:

This study aims to offer a new explanation for the momentum effect in international government bonds. Using cross-sectional and time-series tests, we examine a sample of bonds from 22 countries for the years 1980 through 2018. We document significant momentum profits that are not attributable to bond-specific risk factors, such as volatility or credit risk. The global bond momentum is driven by the returns on underlying foreign exchange rates. Controlling for currency movements fully explains the abnormal returns on momentum strategies in international government bonds. The results are robust to many considerations including alternative sorting periods, portfolio construction methods, as well as subperiod and subsample analysis.

Notable quotations from the academic research paper:

"The various types of momentum effects have also been documented in government bonds, implying that the fixed-income winners outperform fixed-income losers. Although the finance literature extensively discusses the sources of momentum in an equity universe, the specific explanations for momentum in government bonds are rather scarce.

This paper aims to contribute in two ways. First, we provide new evidence on the momentum effect in international government bond markets. Using cross-sectional and time-series tests, we investigate a sample of government bonds from 22 countries for the years 1980 through 2018.

Second, and more importantly, we offer and test two new explanations of momentum. Our first hypothesis builds on Conrad and Kaul (1998): we conjecture that the momentum in bonds may simply capture the cross-sectional variation in long-run returns. In other words, the top performing assets continue to deliver higher returns because they exhibit excessive risk exposure. In particular, we assume that the winner (loser) bonds may display high (low) exposure to duration and credit risks, which drive the excessive long-run returns. The second hypothesis is that the momentum in bonds might be driven by the returns on underlying currencies.

Fund flows

The primary findings of this study can be summarized as follows. We document a strong and robust momentum effect in government bonds. An equal-weighted portfolio of past winners tends to outperform past losers by 0.24–0.35% per month. The effect is not fully attributable to the risk factors in government bonds, which explain 38–55% of the abnormal profits. Nevertheless, the phenomenon is entirely explained by the momentum in underlying foreign exchange rates, which is consistent with our second hypothesis. Once we control for the currency returns in cross-section or time-series tests, the momentum alphas disappear. The results are robust to many considerations, including alternative sorting periods and portfolio implementation methods, as well as subperiod and subsample analyses."


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Three Insights from Academic Research Related to Carry Trade Strategy

27.March 2019

What are the main insights?

– carry trade profitbility depends on the positive order-flow of sophisticated financial customers (hedge funds and asset managers)

– carry trade strategy is profitable, but it is hard to pick correct trading rules ex-ante

– future alpha of a high interest rate currency carry portfolio increases in a trough in a business cycle and in a state of high market uncertainty

1/

Authors: Burnside, Cerrato, Zhang

Title: Foreign Exchange Order Flow as a Risk Factor

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3275356

Abstract:

This paper proposes a set of novel pricing factors for currency returns that are motivated by microstructure models. In so doing, we bring two strands of the exchange rate literature, namely market-microstructure and risk-based models, closer together. Our novel factors use order flow data to provide direct measures of buying and selling pressure related to carry trading and momentum strategies. We find that they appear to be good proxies for currency crash risk. Additionally, we show that the association between our order-flow factors and currency returns differs according to the customer segment of the foreign exchange market. In particular, it appears that financial customers are risk takers in the market, while non-financial customers serve as liquidity providers.

2/

Authors: Hsu, Taylor, Wang

Title: The Profitability of Carry Trades: Reality or Illusion?

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3158101

Abstract:

We carry out a large-scale investigation of the profitability of carry trades, using foreign exchange data for 48 countries spanning a period from 1983 to 2016 and employing a stepwise test to counter data-snooping bias. We find that, while we can confirm previous findings that the carry trade is profitable over this long period when a specific carry-trade strategy is selected based on the whole data set, even after controlling for data snooping, when we split the sample into sub-periods, the best carry-trade strategy in one sub-period is generally not profitable in the next sub-period. This finding holds true even when we include learning strategies and stop-loss strategies. Our findings thus highlight the instability of carry trades over long periods and their limitation in the sense that it is hard to predict their performance based on several years of data and therefore to choose a profitable carry-trade strategy ex ante.

3/

Author: Sakemoto

Title: Currency Carry Trades and the Conditional Factor Model

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3210768

Abstract:

This study employs a conditional factor model in order to investigate the time-varying profitability of currency carry trades. To that end, I estimate conditional alphas and betas on the popular dollar and carry factors through the use of a nonparametric approach. The empirical results illustrate that the alphas and betas vary over time. Furthermore, I find that the alpha of a high interest rate currency portfolio increases in a trough in a business cycle and in a state of high market uncertainty. However, the beta on the dollar factor decreases in these market conditions, suggesting that investors reduce the foreign currency risk exposure.


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Currency Hedging with Currency Risk Factors

23.January 2019

A new research paper related to multiple currency risk factors:

#5 – FX Carry Trade
#129 – Dollar Carry Trade

Authors: Opie, Riddiough

Title: Global Currency Hedging with Common Risk Factors

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3264531

Abstract:

We propose a novel method for dynamically hedging foreign exchange exposure in international equity and bond portfolios. The method exploits time-series predictability in currency returns that we find emerges from a forecastable component in currency factor returns. The hedging strategy outperforms leading alternative approaches out-of-sample across a large set of performance metrics. Moreover, we find that exploiting the predictability of currency returns via an independent currency portfolio delivers a high risk-adjusted return and provides superior diversification gains to global equity and bond investors relative to currency carry, value, and momentum investment strategies.

Notable quotations from the academic research paper:

"How should global investors manage their foreign exchange (FX) exposure? The classical approach to currency hedging via mean-variance optimization is theoretically appealing and encompasses both risk management and speculative hedging demands. However, this approach, when applied out of sample, suff ers from acute estimation error in currency return forecasts, which leads to poor hedging performance.

In this paper we devise a novel method for dynamically hedging FX exposure using mean-variance optimization, in which we predict currency returns using common currency risk factors.

Recent breakthroughs in international macro- nance have documented that the cross-section of currency returns can be explained as compensation for risk, in a linear two-factor model that includes dollar and carry currency factors. The dollar factor corresponds to the average return of a portfolio of currencies against the U.S. dollar, while the carry factor corresponds to the returns on the currency carry trade.

We take the perspective of a mean-variance U.S. investor who can invest in a portfolio of `G10' developed economies. We adopt the standard assumption that the investor has a predetermined long position in either foreign equities or bonds and desires to optimally manage the FX exposure using forward contracts. We form estimates of currency returns using a conditional version of the two-factor model where both factor returns and factor betas are time-varying.

A related literature provides strong empirical evidence, with underpinning theoretical support, that the dollar and carry factor returns are partly predictable. We exploit this predictability to forecast currency returns. Speci ffically, we estimate factor betas and 1-month ahead dollar and carry factor returns in the time series, and then form expected bilateral currency returns using these estimates. This vector of expected currency returns enters the mean-variance optimizer to produce optimal, currency-speci fic, hedge positions. We update the positions monthly and refer to the approach as Dynamic Currency Factor (DCF) hedging.

currency hedging

We evaluate the performance of DCF hedging, over a 20-year out-of-sample period, against nine leading alternative approaches ranging from naive solutions in which FX exposure is either fully hedged or never hedged, through to the most sophisticated techniques that also adopt mean-variance optimization. We nd DCF hedging generates systematically superior out-of-sample performance compared to all alternative approaches across a range of statistical and economic performance measures for both international equity and bond portfolios. As a preview, in Figure 2 we show the cumulative payoff to a $1 investment in international equity and bond portfolios in January 1997. When adopting DCF hedging, the $1 investment grows to over $5 by July 2017 for the global equity portfolio, and to almost $4 for the global bond portfolio. These values contrast with $2 and $1.5, which a U.S. investor would have obtained, if the FX exposure in the equity or bond portfolios was left unhedged."


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