Lessons from the evolution of foreign exchange trading strategies

The adaptive markets hypothesis posits that trading strategies evolve as traders adapt their behavior to changing circumstances. This paper studies the evolution of trading strategies for a hypothetical trader who chooses portfolios from foreign exchange (forex) technical rules in major and emerging markets, the carry trade, and US equities. The results show that a backtesting procedure to choose optimal portfolios improves upon the performance of nonadaptive rules. We also find that forex trading alone dramatically outperforms the S&P 500, with much larger Sharpe ratios over the whole sample, but there is little gain to coordinating forex and equity strategies, which explains why practitioners consider these tools separately. Forex trading returns dip significantly in the 1990s but recover by the end of the decade and have been markedly superior to an equity position since 1998. Overall, trading rule returns still exist in forex markets—with substantial stability in the types of rules—though they have migrated to emerging markets to a considerable degree.     

Order flow, bid-ask spread and trading density in foreign exchange markets

This paper examines the implications of market microstructure for foreign exchange markets. We argue that the usual order flow model needs to be recast in broader terms to incorporate the transaction costs of liquidity and the limitation of price discovery through order flows that involve low trading density currencies. Using a daily data set, we find that order flows are inadequate when it comes to explaining the changes in the low trading density currencies. Alternatively, within the high trading density, both order flows and bid-ask spreads significantly affect the foreign exchange rate returns. Our findings suggest that the order flow model is better at incorporating these microstructure effects except for some currencies with a very high level of trading density.     

Joint dynamics of foreign exchange and stock markets in emerging Europe

This paper proposes an ideal specification for studying joint dynamics of emerging stock and foreign exchange markets, and applies it on European emerging markets where this interaction is of particular significance due to large external deficits. Results show that global developed and emerging stock market returns account for a large proportion of the (permanent) comovement between the stock index and currency value. The residual interaction after controlling for global indexes is small. The sign of the currency-stock market relationship is driven by dependence on foreign capital (predominantly positive for countries which are net receivers of foreign portfolio capital) and depth of the local stock market. Bank of Russia's intensive involvement in the currency market delays Ruble's response to global information. Emerging European currencies predict reversals in global equity indexes several months ahead.     

News announcements and price discovery in foreign exchange spot and futures markets

This paper studies competition in price discovery between spot and futures rates for the EUR–USD and JPY–USD markets around scheduled macroeconomic announcements. Using both the information shares approach and the common factor component weight approach for futures prices from the Chicago Mercantile Exchange (CME), as well as deal prices from spot trading on the Electronic Broking Services (EBS), we gauge how foreign exchange spot and futures markets respond to news surprises. The results show that the spot rates provide more price discovery than do the CME futures rates overall; however, the contribution of the futures rates to price discovery increases in the time surrounding macroeconomic announcement releases.     

The effectiveness of position limits: Evidence from the foreign exchange futures markets

This study considers the effects of the relative size of hedger and speculator open interests and the potential impact of implementing position limits on the price discovery process in both JPY–USD and EUR–USD futures markets. Hedging trading exerts a negative impact, regardless of its size, on price discovery in futures markets. Hedgers are less likely to be information motivated, so their trading uniformly delays the price discovery process. However, there is a positive and nonlinear impact of speculators’ trade size on price discovery, the contribution of which depends on the relative size of the speculative open interest. Contrary to conventional wisdom among regulators, speculative trading does not harm the market in terms of market efficiency; as long as the percentage of speculators’ open interest is below an endogenously determined threshold (approximately 20% for EUR–USD and 16.3% for JPY–USD), speculative trading even improves futures market efficiency.     

Currency momentum strategies

We provide a broad empirical investigation of momentum strategies in the foreign exchange market. We find a significant cross-sectional spread in excess returns of up to 10% per annum (p.a.) between past winner and loser currencies. This spread in excess returns is not explained by traditional risk factors, it is partially explained by transaction costs and shows behavior consistent with investor under- and overreaction. Moreover, cross-sectional currency momentum has very different properties from the widely studied carry trade and is not highly correlated with returns of benchmark technical trading rules. However, there seem to be very effective limits to arbitrage that prevent momentum returns from being easily exploitable in currency markets.     

Short-horizon contrarian and momentum strategies in Asian markets: An integrated analysis

In this paper, we test the profitability of short-term contrarian and momentum strategies, which take into account the effects of trading activity, size/value characteristics, and asymmetric investor responses to news regarding stock markets in Japan, Taiwan, Korea, Hong Kong, Malaysia, Thailand, and Singapore during 1990-2000. Except for the Taiwanese and Korean markets, “winner” (“loser”) portfolios experience subsequent reversal (momentum) of stock prices. Among actively traded stocks, significant contrarian profits can be obtained from only “winner” portfolios in Japan, while sizeable momentum profits from “loser portfolios” in both Japan and Hong Kong.     

Portfolio reallocation and exchange rate dynamics

This paper explains exchange rate dynamics by linking financial customers’ foreign exchange order flow with their dynamic portfolio reallocation. For any currency pair in a particular period, one currency has higher assets return than the other and can be considered the high-return-currency (HRC). Financial institutions attempt to hold more HRC assets when they become more risk-loving or the relative return of the assets is expected to increase. Such a portfolio reallocation generates buy order toward the HRC and the currency appreciates. As the HRC changes over time, the direction that the relative return and risk appetite affect the exchange rate varies in different regimes.     

Day-of-the-week effect in the Taiwan foreign exchange market

This study uses stochastic dominance with and without risk-free assets to examine whether trading days can affect patterns of the day-of-the-week effect in the Taiwan foreign exchange market. Our results generally indicate that higher returns appear on the first three days of the week across different trading-day regimes in the Taiwan foreign exchange market, confirming day-of-the-week effect. Allocating part of investors’ assets in risk-free assets is useful in distinguishing returns among weekdays for all currencies.     

Can Markov switching models predict excess foreign exchange returns?

This paper merges the literature on technical trading rules with the literature on Markov switching to develop economically useful trading rules. The Markov models’ out-of-sample, excess returns modestly exceed those of standard technical rules and are profitable over the most recent subsample. A portfolio of Markov and standard technical rules outperforms either set individually, on a risk-adjusted basis. The Markov rules’ high excess returns contrast with mixed performance on statistical tests of forecast accuracy. There is no clear source for the trends, but permitting the mean to depend on higher moments of the exchange rate distribution modestly increases returns.     

Global liquidity risk in the foreign exchange market

Using a broad data set of 20 US dollar exchange rates and order flow of institutional investors over 14 years, we construct a measure of global liquidity risk in the foreign exchange (FX) market. Our FX liquidity measure may be seen as the analog of the well-known Pastor–Stambaugh liquidity measure for the US stock market. We show that this measure has reasonable properties, and that there is a strong common component in liquidity across currencies. Finally, we provide evidence that liquidity risk is priced in the cross-section of currency returns, and estimate the liquidity risk premium in the FX market around 4.7 percent per annum.     

Volatility transmission in emerging European foreign exchange markets

This paper studies the dynamics of volatility transmission between Central European (CE) currencies and the EUR/USD foreign exchange using model-free estimates of daily exchange rate volatility based on intraday data. We formulate a flexible yet parsimonious parametric model in which the daily realized volatility of a given exchange rate depends both on its own lags as well as on the lagged realized volatilities of the other exchange rates. We find evidence of statistically significant intra-regional volatility spillovers among the CE foreign exchange markets. With the exception of the Czech and, prior to the recent turbulent economic events, Polish currencies, we find no significant spillovers running from the EUR/USD to the CE foreign exchange markets. To measure the overall magnitude and evolution of volatility transmission over time, we construct a dynamic version of the Diebold–Yilmaz volatility spillover index and show that volatility spillovers tend to increase in periods characterized by market uncertainty.     

The trading behavior of institutions and individuals in Chinese equity markets

This paper employs a unique data set to analyze the trading behavior of 4.74 million individual and institutional investors across Mainland China. Results show that groups of individual investors with varying trade values (as proxies for wealth levels) engage in different trading strategies. Chinese institutions are momentum investors, while less wealthy Chinese individual investors at large are contrarian investors. The results also indicate that a small group of wealthiest Chinese individuals tend to behave like institutions when they buy stocks, and behave like less wealthy individuals when they sell. Furthermore, only the trading activities of institutions and of wealthiest individuals can affect future stock volatility, but those of Chinese individual investors at large have no predictive power for future stock returns.     

Evaluating foreign exchange market intervention: Self-selection,counterfactuals and average treatment effects

Estimating the effect of official foreign exchange market intervention is complicated by the fact that intervention at any point entails a “self-selection” choice made by the authorities and that no counterfactual is observed. To address these issues, we estimate the “counterfactual” exchange rate movement in the absence of intervention by introducing the method of propensity-score matching to estimate the “average treatment effect” (ATE) of intervention. To derive the propensity scores we estimate central bank intervention reaction functions. We estimate the ATE for daily official intervention in Japan over the January 1999–March 2004 period. This sample encompasses a remarkable variation in intervention frequencies as well as unprecedented frequent intervention towards the latter part of the period. We find that only sporadic and relatively infrequent intervention is effective.     

Generating currency trading rules from the term structure of forward foreign exchange premia

The quality of an exchange rate forecasting model has typically been judged relative to a random-walk in terms of out-of-sample forecast errors. The difficulty of outperforming this benchmark is well documented, although Clarida and Taylor have demonstrated how the random walk can be beaten in this metric by exploiting information embedded within the term structure of forward exchange rate premia. But this achievement does not guarantee success within an investment context. We therefore assess whether the Clarida-Taylor framework can be used to generate significant trading profits in combination with an acceptable degree of risk in a realistic investment portfolio context.     

Asset pricing and foreign exchange risk

According to the International Capital Asset Pricing Model (ICAPM), the covariance of assets with foreign exchange currency returns should be a risk factor that must be priced when the purchasing power parity is violated. The goal of this study is to re-examine the relationship between stock returns and foreign exchange risk. The novelties of this work are: (a) a data set that makes use of daily observations for the measurement of the foreign exchange exposure and volatility of the sample firms and (b) data from a Eurozone country.The methodology we make use in reference to the estimation of the sensitivity of each stock to exchange rate movements is that it allows regressing stock returns against factors controlling for market risk, size, value, momentum, foreign exchange exposure and foreign exchange volatility. Stocks are then classified according to their foreign exchange sensitivity portfolios and the return of a hedge (zero-investment) portfolio is calculated. Next, the abnormal returns of the hedge portfolio are regressed against the return of the factors. Finally, we construct a foreign exchange risk factor in such manner as to obtain a monotonic relation between foreign exchange risk and expected returns.The empirical findings show that the foreign exchange risk is priced in the cross section of the German stock returns over the period 2000-2008. Furthermore, they show that the relationship between returns and foreign exchange sensitivity is nonlinear, but it takes an inverse U-shape and that foreign exchange sensitivity is larger for small size firms and value stocks.     

Central bank intervention and the intraday process of price formation in the currency markets

We propose a novel theory of the impact of sterilized spot interventions on the microstructure of currency markets that focuses on their liquidity. We analyze the effectiveness of intervention operations in a model of sequential trading in which i) a rational Central Bank faces a trade-off between policy motives and wealth maximization; ii) currency dealers' sole objective is to provide immediacy at a cost while maintaining a driftless expected foreign currency position; and iii) adverse selection, inventory, signaling, and portfolio balance considerations are absent by assumption. In this setting, and consistent with available empirical evidence, we find that i) the mere likelihood of a future intervention—even if expected, non-secret, and uninformative—is sufficient to generate endogenous effects on exchange rate levels, to increase exchange rate volatility, and to impact bid-ask spreads; and ii) these effects are exacerbated by the intensity of dealership competition, the extent of the Central Bank's policy trade-off, and the credibility of its threat of future actions.     

Macroeconomic sources of foreign exchange risk in new EU members

We address the issue of foreign exchange risk and its macroeconomic determinants in several new EU members. We derive the observable macroeconomic factors—consumption and inflation—using the stochastic discount factor (SDF) approach. The joint distribution of excess returns in the foreign exchange market and the factors are modeled using a multivariate GARCH-in-mean specification. Our findings show that both real and nominal factors play important roles in explaining the variability of the foreign exchange risk premium. Both types of factors should be included in monetary general equilibrium models employed to study excess returns. To contribute to the further stability of domestic currencies, the new EU members should strive to implement stabilization policies aimed at achieving nominal as well as real convergence with the core EU members.     

Conditional risk premia in currency markets and other asset classes

The downside risk capital asset pricing model (DR-CAPM) can price the cross section of currency returns. The market-beta differential between high and low interest rate currencies is higher conditional on bad market returns, when the market price of risk is also high, than it is conditional on good market returns. Correctly accounting for this variation is crucial for the empirical performance of the model. The DR-CAPM can jointly rationalize the cross section of equity, equity index options, commodity, sovereign bond and currency returns, thus offering a unified risk view of these asset classes. In contrast, popular models that have been developed for a specific asset class fail to jointly price other asset classes.     

On the sources of private information in FX markets

We investigate the source of information advantage in inter-dealer FX trading using data on trades and counter-party identities. In liquid dollar exchange rates, information is concentrated among dealers that trade most frequently and specialize their activity in a particular rate. In cross-rates, traders that engage in triangular arbitrage are best informed. Better-informed traders are also located on larger trading floors. In cross-rates, the ability to forecast flows explains all of the advantage of the triangular arbitrageurs. In liquid dollar rates, specialist traders can forecast both order-flow and the component of exchange rate changes that is uncorrelated with flow.