Currency Strategies

Just to note: compared to the previous post, this post looks into currencies with proper data and more importantly, accounts for interest rates.

There are four main sources of currency beta: value, momentum, carry, and volatility. Value is described as the PPP strategy, taking advantage of relative differences in long-term reversals to the mean of currencies with overvalued or undervalued currencies (on the basis on inflation and interest rates). Momentum is a trend-following strategy. Carry is investing in high interest rate countries and borrowing in low interest rate countries. A volatility strategy uses options on currencies and would be more exotic than a retail investor would want to use (and is most likely used to take into account exotic strategies a hedge fund manager uses and show that they are most likely just long/short volatility).

Well, I have been interesting in including the Beta of currencies in tactical asset allocation portfolios (see here for original post) and I wanted to experiment with these strategies. I generally am skeptical of the mean-reversion strategy since I've seen the charts of countries deviating from PPP estimates for decades. It's too hard to compare a basket of consumption goods between the countries to measure PPP accurately enough for me to be confident enough to invest using it. Volatility would also be too difficult to test and I've never traded currency options. It might be something to add in the future, but I'm guessing that strategy is too volatile for me...

So I set my eyes on the carry and momentum strategies. The carry strategy is particularly interesting to me since there already is an ETF which does that for you. DBV goes long the highest yielding currencies and short the lowest yielding ones to profit from the spread of the interest rates so long as exchange rates do not move very far. I replicated the strategy using all of the currencies that the ETF uses (and before the Euro I used France and Germany) going back to 1980 (when I could get decent interest rate data for some of the smaller countries). I replicated the DBV strategy as best as I could, except that I had to use some alternative interest rate data with longer histories instead of Libor (and then I continued to use that instead of switching to the country's interbank rates after the interbank data becomes available). I got a 95% correlation with the DBV since it has been in existence with a 10% return with a 7.8% standard deviation since 2000 (however, they report a cumulative return of 518% (14.67% annualized) since inception and I only showed 354% (8.5%), not sure how they account for the Euro, this could be the reason why). It's not perfect, but it's good enough (mine is crude since it may not always be market neutral b/c I'm lazy and don't plan to use it to invest with)

Taking the strategy further back (to 1980), there was a smaller return 6.3% (with 9% std) which could be attributable to wider (or more volatile) interest rate spreads during the 1980s which converged to roughly .4% in recent years. Ultimately the strategy has a very low correlation with the timing strategy that's been developed here and at WorldBeta and with the momentum strategy I will detail below. Also, based on my crude analysis, applying a 10 month moving average to this strategy increases the return:risk ratio from .694 to 1.15 (without including the benefit of being in CP when not using it it is .89). This strategy increases the correlation of the carry trade with both the initial TAA model and the momentum strategy. The increased correlation with the momentum strategy is due to the large influence of currency movements on the carry trade. Interestingly enough, the worst declines in this strategy have been when the market in general goes down (like in 1987 and 1998). However, the momentum strategy does not have the same volatility or exposure to what happens in the equity markets.

The momentum strategy is basically the same as the TAA strategy. I bought currencies above their 10 month MA and stayed in dollars when not in a foreign currency. However, due to the nature of the currency markets, except by hedging, you can never really have no exposure. If I bought euros and converted them to dollars, I'm effectively taking a position in dollars even though it is my home currency. The benefit of this strategy is that I'm always receiving an interest rate, it is either the dollar interest rate or a foreign one, and unless I lever this strategy, I don't necessarily have to borrow in any of them (unlike the carry trade). Anyway, this strategy has a return of about 11.4% with a standard deviation of about 6.6% with practically no correlation to the timing strategy.

Based on the returns and correlations of the two currency strategies, (and between only these two), I originally thought I should allocate about 70-80% of the currency strategy to the carry trade since that is where the Sharpe ratio is greatest for those two strategies. However, that isn't what happens in the context of the entire portfolio. Since the carry trade has greater correlation with the components of the timing model, the Sharpe ratio in an equally weighted TAA portfolio including currencies is maximized when the carry trade has no weight in the currency strategy. Giving this strategy equal weight in the TAA strategy* since April of 1980 would have decreased returns from 12.4% (with std of 6.42%) to 12.3% (with std of 5.5%) and increased the Sharpe ratio from about 1 to 1.14. Giving the currencies double or triple weight would increase the Sharpe ratio further. Even a triple weight on the currency momentum strategy will only reduce the returns by about 20 basis points historically and drops the standard deviation down below 5. Not sure yet the effect on leveraged portfolios, but that is my next step.

Since it was effective to include currencies in the TAA strategy and it is essentially a way to invest in cash, I wondered if it should it be included as the default cash strategy (eg. when the TAA model goes to cash, should it invest in currencies instead)?

Well, that answer is no. Despite the fact that the model outperforms cash with little correlation to TAA, it still will go with the market in the worst periods when the TAA strategy in general should be in cash. However, the cash returns (esp. standard deviation) do not take into account the depreciation of the dollar. All in all, it would probably be a wash and better to just keep the strategy separate, but it might be interesting to test after including the effect of depreciation (and volatility!) of the dollar.

* To be clear, what is tested is using the 10 month strategy on the countries and then investing in that as BH strategy itself. Additionally applying the 10 month strategy to the currency strategy does improve returns and Sharpe ratios for the currency strategy, but does not improve the Sharpe ratio for the overall strategy for some reason. I tested this as an afterthought, but I never wanted to test that as an original strategy, the 10 month MA is already applied individually and it makes little sense to complicate things further, IMO.

Checking your assumptions

Let's say you develop two investment strategies. One is based on tried and true methods and the other is new and innovative. If you discover that you can maximize your excess return:risk by allocating a large portion of your portfolio to the new strategy, check your assumptions.

I've been researching strategies for currencies and adding them to the Tactical Asset Allocation strategy (here). This strategy is already very successful so I was surprised to find out how good a simple currency momentum strategy was when added to the portfolio. I didn't realize at first how important it was to check the assumptions regarding the data. I downloaded the data from the St. Louis Fred website and it was monthly data, I assumed it would be fine. The problem was that the data isn't end of the month data, it is the average of a month's daily data. This is a good thing for running regressions with exchange rates or using them to adjust accounting information, but it's not good for trading strategies. Even creating new month time series with the end of the month or middle of the month dates will dramatically underperform the average series (Global Financial Database has the numbers based on end of month which I will be using in the future). You can only know the average rate for the month at the end of the month so by assuming you get out at the average rate you're assuming that you know the entire month's returns sometime that is not the end of the month.

I originally performed this research by looking at several different currencies until I realized what I did wrong, but it is easier to illustrate with one currency.

Just to illustrate how far off it is, using the strategy (L/S 2 period MA timing) on the Pound going back to 72 (including interest rates), will give a return of about 15.6% (8.1% std) on the average of the month data, 9.64% (10.3% std) on the end of the month data, and 12.4% (9.7% std) on the middle of the month data. The best thing about the strategy is that it has virtually 0 correlation with the TAA model (why it deserves such a huge weight in it originally) using any of the datapoints. That alone leads me to believe that currencies should have a position in a well-diversified portfolio. With the British pound strategy as a proxy for how well the complete momentum (it isn't, but I suspect that strategy will be better), the Sharpe ratio will be increasing with a positive weight on the currency strategy until about 40% (for the middle of month, 25% for end of month). I'm comparing it with the basic TAA model with equal weights on the remaining assets. I can only guess that the well-diversified currency strategy will perform even better and should receive a larger allocation.

To test this without compiling all of the interest rate data and combining everything (next project: recreate the carry trade) I tested a j=4, k=2 momentum strategy on the currency ETFs that are available since September of 2006. This is a very short time frame when all of these ETFs performed very well, but it would represent at least the long-side of the strategy accurately. The strategy would be in either two or three currency ETFs and has a CAGR of 13.8% with a 5.6% standard deviation. I would reiterate again that this is a period of a massive decline in the dollar and it is not expected that this kind of risk:return ratio would continue in the future (the return is expected more than the risk). Over this time period, the strategy (absolute returns) has a correlation with the TAA model of 19%. 19% isn't 0, but it still should be important enough to add to the portfolio after completing a more rigorous long-term examination of the strategy.