There has been a surge in interest with trying to classify foreign exchange trading. This style classification movement is an extension of what has been done in the equity markets and with hedge funds over the last few years. For equity markets, there has been significant interest in trying to analyze value versus growth style effects. For alternative investments, there have been a number of classification schemes to find those factors that best represent returns for hedge funds. Foreign exchange style identification has moved beyond comparisons to simple benchmarks like a basket of exchange rates and has focused on measuring trading strategies. Banks, starting with ABN-Amro, have classified foreign exchange trading into four distinct styles: trend-following, carry, volatility, and valuation. This certainly does not capture the value-added from many managers but it does increase the level of transparency associated with FX traders.
The trend-following style attempts to generate return through using simple moving average principles. Long exposure is held in those markets which have an uptrend and short exposure is held for those which are trending down. Positions are a weighted average of cross-over signals with different time lengths or look-back periods. There is no risk management or stop loses with this style, only a trend identification procedure. The style only looks at the value of trending without any other indicators such as relative strength. Signals could be easily replicated with a simple spreadsheet.
The carry style holds long exposure in a set of those currencies which have the highest short-term yield. Short positions are held in those currencies that have the lowest yield. The carry strategy is based on the belief that money will flow to those countries that have high nominal interest rates causing the currency to appreciate. Again there is no risk management and positions are equally weighted without any input on the relative size of the yield positions. Banks will often separate carry models into developed and emerging market portfolios.
The valuation strategy could focus on a number of models but often uses a simple purchasing power parity equation. It buys those currencies that seem cheap relative to PPP and shorts those which are overvalued against relative inflation rates. The long and short positions are based on the assumption that exchange rates will mean revert to their fair value. Positions are only taken in those currencies that deviate by a specific percentage.
The volatility strategy will buy straddle for those currencies that have low volatility and sell those currencies which have high volatility.
The correlation of these strategies or styles is low. A simple correlation table since the end of 2000 shows that each strategy is somewhat unique. There is gain from forming a diversified portfolio of these strategies. Volatility from a combination is lower than would be found from just forming a weighted average of these strategies.
Nevertheless, the performance of these strategies has changed markedly over the last five years. Trend-following which has been one of the best strategies for currencies has shown negative performance over the last five years. Volatility trading has flat-lined over the last few years as volatility in the currency markets has declined and stabilized. Given the decline with inflation around the globe, there has been a limit in the deviations away from fair value for developed currencies. The greater stability in fundamentals, trends, and volatility has made the carry strategy a winner over these same periods. In fact, employing only the carry strategy would have provided the best overall return over the last five years. A mixed strategy would have created a lower volatility portfolio but would have cost investor’s return. Running a simple optimization of these strategies would create a portfolio which is almost completely skewed to carry strategies. There is no need to use anything else, except this is looking back in time. This is the classic corner solution when employing an optimizer.
So what does style analysis tell us about forming a foreign exchange portfolio? A stable market environment means that a high exposure to carry strategies is most effective. The stable economic environment across the globe creates limited appeal for the valuation strategy. Trend-following will only work if there are large dislocations expected in the markets. Volatility strategies will have limited value if there is stable and low volatility.
Nevertheless, it is not clear what will be the market environment in the future. A strategy of holding high exposure to carry over the next five years may not be appropriate. Hence, forming a balanced strategy may still make sense especially if you have clear expectations on the global environment which suggest greater uncertainty.
Preparing for the future may require careful analysis of FX styles and views on the future global environment. It is easy to argue the extremes that carry should continue to dominate or that we will find a less favorable carry environment as strategy performance reverts back to a mean. Markets have a tendency to do the unexpected, so a balance of strategies may be the most prudent.
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