Momentum strategy is a very well known and robust anomaly and has been documented in several different assets across the world. It was originally discovered in equity markets, but momentum has strong results also in currencies. It is probably the most investigated anomaly and financial academics consider it as the one of the strongest.

Keywords:

momentum, FX anomaly, forex system

Source Paper

Abstract:

Momentum — A widely observed feature of currency markets is that many Exchange rates trend on a multi-year basis. Therefore a strategy that follows the trend typically makes positive returns over time. The segmentation of currency market participants with some acting quickly on news while others respond more sowy is one reason why trends emerge and can be protracted

Other Papers

Menkhoff, Sarno, Schmeling, Schrimpf: Currency Momentum Strategies

Abstract:

We provide a comprehensive empirical investigation of momentum strategies in foreign exchange markets which covers the period from 1976 to 2010 and more than 40 currencies. We find a large and significant cross-sectional spread in excess returns of up to 10% p.a. between past winner and past loser currencies, i.e. currencies with high recent returns continue to outperform currencies with low recent returns by a significant margin. Similar to momentum in equity markets, this spread in excess returns is not explained by traditional risk factors and shows behavior consistent with investor over- and underreaction. Moreover, currency momentum is mostly driven by return continuation in spot rates (and not interest rate differentials) and has very different properties from the widely studied carry trade. However, there seem to be effective limits to arbitrage which prevent momentum returns from being exploitable in foreign exchange markets. Momentum portfolios incur large transaction costs and are heavily skewed towards currencies with high idiosyncratic volatility and high country risk.

Bianchi, Drew, Polichronis: A Test of Momentum Trading Strategies in Foreign Exchange Markets: Evidence from the G7

Abstract:

In this trading strategy study, we ask three questions. First, does momentum exist in foreign exchange markets? Second, what is the impact of transactions costs on excess returns? And, third, can a consolidated trading signal garner excess returns and, if so, what is the source of such returns? Using total return momentum strategies in the foreign exchange markets of the G7 for the period 1980 through 2004, the answers from this study are as follows: we find evidence of momentum; however, such momentum appears transitory, particularly for longer look back periods. As expected, transaction costs have a material negative impact on excess returns. Finally, a consolidated signal garners excess returns; however, a bootstrap simulation finds the source of these returns is a function of autocorrelation.

Kroencke, Schindler, Schrimpf: International Diversification Benefits with Foreign Exchange Investment Styles

Abstract:

Style-based investments and their role for portfolio allocation have been widely studied by researchers in stock markets. By contrast, there exists considerably less knowledge about the portfolio implications of style investing in foreign exchange markets. Indeed, style-based investing in foreign exchange markets is nowadays very popular and arguably accounts for a considerable fraction in trading volumes in foreign exchange markets. This study aims at providing a better understanding of the characteristics and behavior of stylebased foreign exchange investments in a portfolio context. We provide a comprehensive treatment of the most popular foreign exchange investment styles over the period from January 1985 to December 2009. We go beyond the well known carry trade strategy and investigate further foreign exchange investment styles, namely foreign exchange momentum strategies and foreign exchange value strategies. We use traditional mean-variance spanning tests and recently proposed multivariate stochastic dominance tests to assess portfolio investment opportunities from foreign exchange investment styles. We nd statistically signi cant and economically meaningful improvements through style-based foreign exchange investments. An internationally oriented stock portfolio augmented with foreign exchange investment styles generates up to 30% higher return per unit of risk within the covered sample period. The documented diversi cation bene ts broadly prevail after accounting for transaction costs due to rebalancing of the style-based portfolios, and also hold when portfolio allocation is assessed in an out-of-sample framework.

Amen: Beta’em Up: What is Market Beta in FX?

Abstract:

In asset classes such as equities, the market beta is fairly clear. However, this question is more difficult to answer within FX, where there is no obvious beta. To help answer the question, we discuss generic FX styles that can be used as a proxy for the returns of a typical FX investor. We also look at the properties of a portfolio of these generic styles. This FX styles portfolio has an information ratio of 0.64 since 1976. Unlike its individual components, the FX styles portfolio returns are relatively stable with respect to underlying regimes in S&P500. Later we replicate FX fund returns using a combination of these generic FX styles. We show that a combination of FX trend and carry, can be used as a beta for the FX market. Later, we examine the relationship between bank indices and these generic FX styles. We find that there is a significant correlation in most instances, with some exceptions.

Accominotti, Chambers: Out-of-Sample Evidence on the Returns to Currency Trading

Abstract:

We document the existence of excess returns to naïve currency trading strategies during the emergence of the modern foreign exchange market in the 1920s and 1930s. This era of active currency speculation constitutes a natural out-of-sample test of the performance of carry, momentum and value strategies well documented in the modern era. We find that the positive carry and momentum returns in currencies over the last thirty years are also present in this earlier period. In contrast, the returns to a simple value strategy are negative. In addition, we benchmark the rules-based carry and momentum strategies against the discretionary strategy of an informed currency trader: John Maynard Keynes. The fact that the strategies outperformed a superior trader such as Keynes underscores the outsized nature of their returns. Our findings are robust to controlling for transaction costs and, similar to today, are in part explained by the limits to arbitrage experienced by contemporary currency traders.

Orlov: Currency Momentum, Carry Trade and Market Illiquidity

Abstract:

This study empirically examines the effect of equity market illiquidity on the excess returns of currency momentum and carry trade strategies. Results uniformly show that equity market illiquidity explains the evolution of strategy payoffs, consistent with a liquidity-based model. Comprehensive experiments, using both time-series and cross-sectional specifications, show that returns on the strategies are low (high) following months of high (low) equity market illiquidity. This effect is found to withstand various robustness checks and is economically significant, approximating in value to one-third of average monthly profits.

Bae, Elkamhi: Global Equity Correlation in Carry and Momentum Trades

Abstract:

We provide a risk-based explanation for the excess returns of two widely-known currency speculation strategies: carry and momentum trades. We construct a global equity correlation factor and show that it explains the variation in average excess returns of both these strategies. The global correlation factor has a robust negative price of beta risk in the FX market. We also present a multi-currency model which illustrates why heterogeneous exposures to our correlation factor explain the excess returns of both portfolios.

Filippou, Gozluklu, Taylor: Global Political Risk and Currency Momentum

This paper investigates the role of political risk in the currency market. We propose a measure of global political risk relative to U.S. that captures unexpected political conditions. Global political risk is priced in the cross-section of currency momentum and it contains information beyond other risk factors. Our results are robust after controlling for transaction costs, reversals and alternative limits to arbitrage. The global political environment affects all currencies; investors following momentum strategies are compensated for the exposure to the global political risk of those currencies they hold, i.e. the past winners, while past losers provide a natural hedge.

Pojarliev, Levich: A New Look at Currency Investing