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# Parametric Portfolio Policy using Currencies as an Asset Class

**Arnar Ingi Einarsson
**

cpr. 221180-3145

A dissertation by

submitted to the Faculty of Economics in partial fulllment of the requirements for the degree of Master of Science in Advanced Economics and Finance.

Supervisor: Lisbeth la Cour, PhD

Copenhagen Business School December 6, 2012 CBS-MS-2012-1 Pages:76 Characters: 112.000

Copenhagen Business School Faculty of Economics Porcelænshaven 16 A, 1 DK-2000 Frederiksberg Tlf: +45 3815 2575, Fax: +45 3815 2576 www.cbs.dk

Preface

This thesis was prepared at the Department of Economics, of Copenhagen Business School in Denmark in partial fulﬁllment of the requirements for acquiring the Master of Science degree in Advanced Economics and Finance. The project was carried out over the period from June 1st 2012 to December 6th 2012. The subject of the thesis is practical asset allocation with the parametric portfolio policy using currencies as an asset class.

Frederiksberg, Desember 2012 Arnar Ingi Einarsson

Summary

A recent innovation in asset allocation was introduced by Brandt et al. [2009] where they propose a dynamic parametric model for asset allocation called Parametric Portfolio Policy (PPP). The method is very adaptable and can be used on diﬀerent asset classes. The aim of this thesis is to analyse how it would perform when using currencies as an asset class. The PPP was found to give robust performance in and out of sample. The model was benchmarked to the APT model and was found to give superior performance. The limitations to the method were found to be that it only considers asset speciﬁc variables and that it requires considerable modeling. In order to pave the way of PPP into practice the modeling code is supplied.

Contents

1 Introduction 1.1 1.2 1.3 2 A 2.1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Aim of thesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outline of thesis . . . . . . . . . . . . . . . . . . . . . . . . . . . M Asset Management . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.1 2.1.2 2.2 Risk Management . . . . . . . . . . . . . . . . . . . . . On Risk in Asset Management . . . . . . . . . . . . . .

1 1 2 3 4 4 6 9 9 10 12

Asset Allocation Methods . . . . . . . . . . . . . . . . . . . . . . 2.2.1 2.2.2 Deﬁciency of Markowitz . . . . . . . . . . . . . . . . . . Fixes to the Markowitz deﬁciencies . . . . . . . . . . .

CONTENTS

2.2.3 2.3 Arbitrage Pricing Theory . . . . . . . . . . . . . . . . .

vi

13 15 16 17 18 21 21 22 23 23 24 26 28 31 33 36 36 38 38

PPP Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 2.3.2 Estimation and Statistical Inference . . . . . . . . . . . Literature Review . . . . . . . . . . . . . . . . . . . . . .

2.4

Concluding on Asset Management . . . . . . . . . . . . . . . .

3 Monetary Economics 3.1 Monetary Economics Theory . . . . . . . . . . . . . . . . . . . . 3.1.1 3.1.2 3.1.3 3.1.4 3.1.5 3.2 Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . Covered Interest Parity, CIP . . . . . . . . . . . . . . . Uncovered Interest Parity, UIP . . . . . . . . . . . . . . Purchasing Power Parity, . . . . . . . . . . . . .

Complete Theory of Exchange Rates . . . . . . . . . .

Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.1 3.2.2 The Toolbox of Central Bankers . . . . . . . . . . . . . History of Currencies . . . . . . . . . . . . . . . . . . .

3.3

Practical Monetary Economics . . . . . . . . . . . . . . . . . . . 3.3.1 3.3.2 3.3.3 The Market for Foreign Exchange . . . . . . . . . . . . Currency Analysis . . . . . . . . . . . . . . . . . . . . . Economic factors . . . . . . . . . . . . . . . . . . . . . .

CONTENTS

3.3.4 3.4 4 M 4.1 Market Sentiment - The Real Market Movers . . . . .

vii

40 42 43 43 46 48 50 52 53 54 60 62 62 64 64 65 71 73

Technical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . D Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1.1 4.1.2 4.1.3 Diﬀerent Modeling procedures . . . . . . . . . . . . . . Statistical Inference . . . . . . . . . . . . . . . . . . . . Benchmark . . . . . . . . . . . . . . . . . . . . . . . . . .

4.2

Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.1 4.2.2 4.2.3 Optimal set of Data . . . . . . . . . . . . . . . . . . . . Data Resources . . . . . . . . . . . . . . . . . . . . . . . Limitations of the Analysis . . . . . . . . . . . . . . . .

5 Modeling Results 5.1 5.2 Summary of Results . . . . . . . . . . . . . . . . . . . . . . . . . General Results . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2.1 5.2.2 5.2.3 6 Conclusion Comparison of Modeling Procedures . . . . . . . . . . Results for P2 . . . . . . . . . . . . . . . . . . . . . . . Bootstrapping Results - Standard error . . . . . . . .

CONTENTS

6.1 6.2 A D A.1 Summary of Results . . . . . . . . . . . . . . . . . . . . . . . . . Further Work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A Exploratory Data Analysis . . . . . . . . . . . . . . . . . . . . .

viii

73 74 77 77 88 88 89 90

B Programming B.1 The R Language . . . . . . . . . . . . . . . . . . . . . . . . . . . B.2 R code . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bibliography

List of Tables

5.1 5.2 5.3 5.4 5.5

Results for diﬀerent modeling procedures. . . . . . . . . . . . . Results for Quarterly data from modeling process P2. . . . . . Results for Monthly data modeling process P2. . . . . . . . . . Results for Daily data from modeling process P2. . . . . . . . Currency and period speciﬁc results from Model (26). . . . . .

66 67 69 70 71

List of Figures

2.1 2.2

Asset Management Process . . . . . . . . . . . . . . . . . . . . Asset Management Process that Incorporates Investor Views . Simple Regression like Modeling Process P1. . . . . . . . . . Stepwise Modeling Process P2. . . . . . . . . . . . . . . . . . . One Step Modeling Process P3. . . . . . . . . . . . . . . . . . Quarterly Exchange Rates Returns from Q3-1992 to Q2-2012. Data are centered to the ﬁrst observation . . . . . . . . . . . . Mean Variance Analysis with Eﬃcient Frontiers. . . . . . . . . Cumulative Return of Diﬀerent Modeling Procedures. . . . . . Monthly Exchange Rates Returns from Q3-1992 to Q2-2012. Data are indexed to the ﬁrst observation . . . . . . . . . . . .

5 19

4.1 4.2 4.3 4.4

47 48 48

56

5.1 5.2

63 65

A.1

79

LIST OF FIGURES

A.2 Correlation of Monthly Exchange Rates for the period Q31992 to Q2-2012. . . . . . . . . . . . . . . . . . . . . . . . . . . GDP from Q3-1992 to Q2-2012. . . . . . . . . . . . . . . . . . Correlation of GDP from Q3-1992 to Q2-2012. . . . . . . . . . Foreign Reserves from Q3-1992 to Q2-2012. It is apparent that smaller economies hold larger proportions of their GDP in foreign reserves. . . . . . . . . . . . . . . . . . . . . . . . . . . Current Account as a ratio of GDP from Q3-1992 to Q2-2012. 10 Year Bond Yields from Q3-1992 to Q2-2012. . . . . . . . . Consumer Price Index from Q3-1992 to Q2-2012. . . . . . . . M2 Money Supply from Q3-1992 to Q2-2012. . . . . . . . . .

xi

80 81 82

A.3 A.4 A.5

83 84 85 86 87

A.6 A.7 A.8 A.9

C

1

Introduction

1.1

Background

A recent innovation in asset allocation was introduced by Brandt et al. [2009], where they propose a new method for optimizing portfolios. This method named parametric portfolio policy (PPP) by the authors should be of great interests to participants in ﬁnancial markets. As the name implies this is a parametric method, where each asset’s portfolio weight are directly estimated by using asset speciﬁc variables. This computationally simple method can easily be modiﬁed and extended to meet diﬀerent purposes. A great feature of the PPP is that it can be applied to all asset classes i.e. stocks, bonds and currency portfolios. As currencies are of major importance in ﬁnancial markets, it is chosen as the asset class under consideration. Currencies are probable the single most important factor in asset allocation as they are an asset type, and act as a denominator in stocks, commodities and bonds. The PPP seems to be well suited for constructing currency portfolio’s as it uses asset-speciﬁc variables to optimally select portfolio weights. Currencies are generally seen as a reﬂection of the health of the economy where it is

1.2 Aim of thesis

used and there are quite many metrics on economic health available.

2

1.2

Aim of thesis

The objective of this thesis is to show the PPP in action, document the modelling procedure and evaluate its performance in predicting return from currencies. Furthermore, to show that it can be applied with data that are of diﬀerent frequencies, i.e. quarterly, monthly and daily data. This would be of great importance as economic data are released with diﬀerent frequencies. As the quality of data available to students is not compatible to the quality that can be expected to be available to banks. Due to this lack of quality data there is thus little focus on analysing the eﬀect of each descriptive variable on model performance1 . The focus will be on contributing to the theory by providing a practical perspective on how PPP could be developed to be used in practice. A comprehensive guide to how to implement PPP will be provided and suggestions on how the modeling process could be improved will be provided. All R code will be made available, which will hopefully ease the way for PPP to become used in practice. The performance of the PPP model is benchmarked to the Markowitz model and the Arbitrage Pricing Theory (APT). The PPP outperformed the benchmark models but the PPP is a dynamic model whereas the others are static. Modeling issues and limitations to the PPP are documented and discussed. It is concluded that the PPP model is attractive in an economic sense as it seems to be able to be implemented into a proﬁt machine and could as such be applied by market participant, whether it is central banks, or in high frequency trading. Furthermore, it is concluded that the PPP could lead to advances in academic research on how ﬁnancial markets work in practice, that could eventually lead to policy changes for the greater good of the general public.

Data were collected through Thomson Reuters DataStream database Thomson Reuters [2012] spanning the past twenty years.

1

1.3 Outline of thesis

1.3 Outline of thesis

3

This thesis is related to two diﬀerent ﬁelds of study, Asset Allocation and Monetary Economics and moreover the practical side of those ﬁelds. The structure of the thesis is as follows. C C C C C A A : A M . Introduces the asset management process and the PPP methodology along with other asset allocation methods. : M E . Gives a brief discussion on theory and applied aspects of monetary economics. : M D . Gives a quite detailed description on the methodology used and description of the data used in the analysis. : M R . The main ﬁndings are presented.

: C . Concludes on the thesis and includes a section about further work. A: D thesis. A . Additional description of the data used in the

B: P . An introduction to R, the programming language used. Includes a description of how the modeling results can be regenerated.

C

2

Asset Management

This chapter focuses on the theory of asset management and introduces the asset management process. Fundamental asset allocation methods are presented and discussed. In Section 2.1 the asset management process is discussed and the role of currencies in ﬁnancial markets is explored. In Section 2.2 fundamental asset allocation methods are presented and discussed. Section 2.3 introduces the Parametric Portfolio Policy (PPP) method and Section 2.4 concludes on asset management.

2.1

Asset Management

As the main subject of this thesis is practical asset management, using currencies as an asset class, it is an ideal starting point to deﬁne what asset management is and which role currencies play in asset management. Asset management can be deﬁned as the practice of managing assets in order

2.1 Asset Management

Measureable Risk Risk Assessment Asset Manager Investor Model Selection Expected Return & Risk Un-measureable Risk Preferences Decision Model Portfolio Weights Return

5

Figure 2.1: Asset Management Process

to achieve the greatest historical return as possible. This deﬁnition can be deepened further by deﬁning asset management as the ongoing process of maximizing returns while minimizing risk for all imaginable horizons. It is thus necessary to evaluate potential returns and all possible risk factors inﬂuencing each asset class as well as individual asset. Considering the asset management process in Figure 2.1, investors really face a numerous set of separate problems. First, is the deﬁnition of investor preferences, i.e. the risk that the investor is willing to accept, in order to attain a certain return. Second, is to develop a risk assessment framework, i.e. a methods for measuring and forecasting risk and return of assets. The risk exposure can be divided into measurable and unmeasurable risk. It is important to note that measurable risk is the only risk considered in a risk assessment process. Measurable risk can then be divided further into asset speciﬁc and asset unspeciﬁc risk. The framework for risk assessments must be intuitively appealing and understandable to the investor. Third, is the model selection process. There is a wide variety of risk assessment models within the asset pricing and asset allocation framework, all with their particular strengths and weaknesses. Finally, there is the issue of estimation error. The quality of the estimation and forecasting of measurable risk is diﬃcult to estimate ex ante. Decisions made based on forecasts of

2.1 Asset Management

6

measurable risk, are subjected to measurement error. The realized return is also subjected to unmeasurable risk. Even ignoring the fact that markets can act quite irrationally, it can be concluded that asset management is not an easy task.

2.1.1

Risk Management

Assets under management can be be divided into groups such as equities, commodities, currencies, ﬁxed income, real estate and other properties, with the ﬁrst four asset classes traded on ﬁnancial markets. From a risk perspective diﬀerent asset groups are subjected to diﬀerent risk factors. Introduction of risk factors for the diﬀerent asset classes that are traded on ﬁnancial markets follows. The discussion on ﬁxed income is based on risk deﬁnitions from Alexander and Sheedy [2005] and Zenios [2005], while the risk factors for the other asset classes were identiﬁed by the author. The discussion is by no mean a complete list of risk factors and is supposed to show the importance of currencies in asset management.

Fixed Income

The ﬁxed income market is a decentralized, over-the-counter (OTC) market splitted into a primary and secondary markets. The yield of bonds1 reﬂects the riskiness of that particular bond. Fixed income as an asset group is subject to counter-party or credit risk. i.e. the risk that the issuer of the bond does not repay the debt. The holder of the bond is then subjected to maturity or market risk, i.e. of change in the value of the bond from issuance to maturity. Convexity risk is the risk of adverse changes in the convexity of the bond yield curve. interest rate risk is the risk of changes in interest rates. Convexity risk and interest rate risk can also be considered as part of the market risk. Currency denomination risk is the risk that the bond denomination currency

1 Fixed income securities or bonds can be sectioned into many subgroups, based on the issuers credit-worthiness; investment-grade or junk (high-yield), based on the issuer; government or corporate and based on duration short-term, intermediate, long-term based on location domestic, foreign, emerging markets; or Convertible bond if the debt can be converted into equity. There are also option embedded bonds, most commonly callable bonds where the issuer has the right to redeem all or part of the debt before the speciﬁed maturity date.

2.1 Asset Management

7

depreciates in value. Bonds are often dollar denominated to increase their liquidity. Then there is liquidity risk, as bond yields are also sensitive to the level of liquidity. If a call provision exist, the investor faces a call risk that the bond will be called before maturity, the same investor then faces a reinvestment risk, i.e. the risk that she will be unable to purchase another security of similar return upon the expiration of the current security.

Commodities

Commodities are traded by future contracts on regulated commodities exchanges, in which they are bought and sold in standardized contracts. Commodities can be divided into the subgrops of metals, energies and soft commodities2 . Commodity risk refers to the uncertainties of future market values and can be sectioned into supply and demand risks as there are usually uncertainties on both sides. Resources risk is the supply side risk as there is often some uncertainty about the volume and cost of the supply. For example; the uncertainty of harvesting volumes of grains and extraction cost of metals. On the demand side there is also some uncertainty on the demand mostly due to uncertainty of global economic health i.e. economic risk. Then there is speculative risk, the risk that speculators make up a large demand or selling interest based on their speculations. This risk factor probable makes up for large price ﬂuctuations in commodities3 . Commodities are also subjected to currency denomination risk as they are denominated in some currency, most often in U.S. dollars. This fact has led the U.S. economy to beneﬁt from this dollar denomination of commodities, as money creation can be transformed into commodity creation. This fact also leads to external intervention risk as the U.S. and to some degree other economies have been running wars and overthrowing governments in order to gain control of resources4 .

Metals being gold, silver, palladium, copper, etc.. Energies being; WTI crude, heating oil, gasoline, natural gas, etc.. Softs being; sugar, coﬀee, cocoa, grains, soy beans, livestock, etc.. 3 The topic whether speculation can drive up commodity prices is a debated topic, for arguments fore see [Bos and van der Molen, 2010], [Masters, May 20. 2008], [Masters and White, 2008a,b, 2009], [Bank, 2008] and against [Irwin et al., 2009] and [Irwin and Sanders, 2010] 4 There is very limited academic research available on this delicate subject. See [Clark, 2005] and references therein.

2

2.1 Asset Management

Equities

8

The risk factors for equities can be sectioned into two major risk factors, systematic risk and ﬁrm-speciﬁc risk. Considering ﬁrst the systematic risk, it is the risk of arbitrary price movements, of stock value, due to external factors. Systematic risk can be divided into sector risk, country risk, index risk and currency denomination risk. There can be an arbitrary price movement of a particular sector, country or market index even though a single ﬁrm within that segmentation is doing well. As an example of country and sector risk, an Italian bank that has extremely healthy ﬁnancial statements can be hugely oversold if there is a certain risk aversion against Italian stock and the banking sector. If that particular stock would be in some cross European stock index, which were also being sold, that would constitute to being an example of index risk. As an example of currency denomination risk a Chinese investor could be exposed to currency denomination risk if he was exposed to U.S. stock at the time of devaluation of the dollar given that the U.S. stock value is fully independent or negatively eﬀected by dollar value. Using an APT framework, Gupta and Finnerty [1992], ﬁnd that currency risk is generally not priced in equity prices and thus not diversiﬁable. Now considering ﬁrm-speciﬁc risk, each individual stock is subjected to some operating risk, which can be explained by uncertainty in revenues and expenditures. This uncertainty can be caused by currency, commodity and economical risk factors. Then there is also the risk of poor management or agency cost risk. It is thus clear that equities are both directly and inderectly subjected to currency risk.

Currencies

Currencies are like the other asset classes subjected to a series of risk factors. Economic risk is the risk that the economy is under-performing the general expectation of the market, e.g. higher inﬂation, slower economic growth, etc.. There are numerous economic measures published for each economy, those measures will be given a more elaborate discussion in section 3.3.2. Interventional risk is the risk that a central bank takes some action that inﬂuence their home currency, e.g. lowers interest rates. Banking risk is the risk

2.2 Asset Allocation Methods

9

that there is excessive bank lending in this currency/economy, that leads to a credit crisis that constrain economic activity and thus leads to a weaker currency. Furthermore, there is the risk of currency crisis following a bank crisis. Fiscal risk is the risk of politicians running to much budgetary deﬁcits for a prolonged period that results in burdensome ﬁscal situation, where debt payments weighs so much on the economy that it constrains economic activity.

2.1.2

On Risk in Asset Management

All asset classes are then exposed to inﬂation risk that is the risk that the purchasing power decreases over the investment period. All economies are then exposed to Political risk which can be sectioned into political uncertainty risk and legal risk. Political uncertainty risk rises when some political uncertainty aﬀects the countries economic outlook. Legal risk, is the risk that some legislation regarding a speciﬁc asset class is changed or that tax rates on a speciﬁc asset class is increase. Allocation risk refers to diminishing returns due to re-allocation of assets into other asset classes, e.g. sale of stock to buy bonds or commodities. Furthermore, all economies are subjected to event risk, which can be a natural disaster, terrorist attack or war, etc.. It is interesting to evaluate the relationship between the asset groups. Interestingly enough is that all asset groups that are traded on ﬁnancial markets are subject to currency risk, showing its importance in asset management. Even though it is not a dominating risk eﬀect for all assets it is still important if maximum return and diversiﬁcation is the objective.

2.2

Asset Allocation Methods

At the heart of asset allocation lies the revolutionary work of Markowitz [1952] on mean-variance analysis. Mean-variance analysis studies the tradeoﬀ between portfolio reward, as measured by the portfolio expected return, and portfolio risk, as measured by its variance. The traditional Markowitz model

**2.2 Asset Allocation Methods
**

can be deﬁned as follows, max ω

ω

10

− ω Σ−1 ω

(2.1)

st ω 1=1 where ω are the optimal portfolio weights, is the variance of returns. are the expected returns and Σ

Even though the revolutionary work of Markowitz has the beneﬁts of being simple and provides good intuition about the relation between returns, variance as a measure of risk and correlation of assets, it is quite ineﬃcient in practice. Following is a discussion of some of the deﬁciencies.

2.2.1

Deﬁciency of Markowitz

As the expected returns and covariance matrix need to be estimated, the portfolio choice problem is subjected to what is known in the literature as estimation risk. Estimation risk is the eﬀect of estimation error, Best and Grauer [1991] show that mean-variance eﬃcient portfolio’s weights are extremely sensitive to changes in asset means, even though the portfolio’s returns are virtually unaﬀected. Chopra and Ziemba [1993] conﬁrm their ﬁndings and conclude that the impact of estimation error in the mean has up to ten times as strong impact as an estimation error in the variance. By using a Bayesian approach Bengtsson [2003] contradicts the results from Chopra and Ziemba [1993] in that estimating the covariance matrix correctly is strictly less important than estimating the mean vector correctly. Furthermore, estimation is conducted using historical data and does thus present past dynamics and furthermore depend on the quality and time span of the data. Even if the quality of data is perfect their might always be errors in the estimates, consider two ﬁrms in the same sector where one is established and the other one has experienced high growth until now. Historically the growth ﬁrm might have had greater returns and had low correlation with the other ﬁrm, but in the future the returns might be similar and a higher correlation would be observed. As the number of assets increases the mean-variance analysis gets computa-

2.2 Asset Allocation Methods

11

tionally heavy, it requires modeling N ﬁrst and (N 2 + N)/2 second moments of returns. The mean-variance analysis does not consider higher moments of return, the investor may be concerned with the skewness of the return distribution or the probability of very large negative shocks measured e.g. by the fourth moment. Furthermore, The mean-variance analysis does not consider any speciﬁc sources of risk and it can thus be concluded that it does not capture the general complexity of risk. It is also necessary to ensure positive deﬁniteness of the covariance matrix, which is not always ensured by just calculating the covariance matrix5 . If the number of assets is large, it is particularly hard to obtain reliable estimates of the N covariance matrix. In particular if the covariance matrix, Σ, is close to singular it’s inverse Σ−1 will be extremely sensitive to uncertainty. Also mean-variance analysis treats gains and losses symmetrically. Variance is a general measures of risk or uncertainty in statistics but investors do not treat gains and losses symmetrically. They only want to minimize downside risk i.e. losses. Finally, Jorion [1985] and DeMiguel et al. [2009] show that the result of the traditional Markowitz model result in extreme optimal portfolio weights. That is that along the eﬃcient frontier there are large positioning in few assets only and substantial changes along the eﬃcient frontier. It is also important to note that the Markowitz model is expected to be a poor model for forming a currency portfolio. This is due to the close relation of economic fundamentals and political issues that the mean and variance can by no mean capture. In order to state this in a bit more theoretical terms the Markowitz model only considers a ﬁxed information space, while the PPP can use the same space and additional space provided by other variables. It is thus not compatible to compare the Markowitz model with the PPP considering the diﬀerence in informational spaces. The comparison of model performance can be seen in the results Chapter 5.

5

See [Kwan, 2010]

**2.2 Asset Allocation Methods
**

2.2.2 Fixes to the Markowitz deﬁciencies

12

Diﬀerent approaches have been proposed to solve some or many of those problems, ﬁrst to mention is putting restrictions on portfolio weights. This is done to solve the problem of extreme portfolio weights. Short-selling restrictions is the most commonly applied constrain as it is commonly considered hard for the private investor to sell short, even though this is becoming increasingly more accessible to private investors. Furthermore, a maximum exposure restriction can be applied and a recent innovation by DeMiguel et al. [2009] of norm constrained portfolios serves the same purpose. Jagannathan and Ma [2002] show that the introduction of short-selling restriction improve out-ofsample performance substantially. Introduction of these additional constraints increases the computational burden of the optimization quite signiﬁcantly. Second, imposing a factor structure on the covariance matrix. There is a large empirical literature on this, see e.g. Ledoit and Wolf [2003, 2004], Jagannathan and Ma [2003], Chan et al. [1999] and Kawakatsu [2006]. As and example, if N is reasonably small, it is possible to estimate the expected mean and variance by a multivariate autoregressive conditional heteroskedastic (MARCH) model, forecast the time varying conditional mean and variance and plug these into the Markowitz framework. Third, Jorion [1985] suggests trying to deal with estimation risk by shrinking the portfolio weights. The shrinking target has been the key diﬀerence where Jorion [1985] shrinks expected returns to a common mean or towards the minimum variance portfolio. Wheras Black and Litterman [1992] and Pástor [2000] shrink towards the market portfolio. Pástor [2000] and Pastor and Stambaugh [2000] suggest introducing an asset pricing model into the Markowitz model. In contrast to Pástor [2000], Black and Litterman [1992] allows the investor to have a view on future returns. Finally, the ground-breaking work of Black and Litterman [1992] provides the investor the opportunity to have views and to blend the investors views with prior information. This is done by using heuristic approaches relying on Bayesian Statistics, by providing the Markowitz model with an intuitive prior, the CAPM equilibrium market portfolio, as a starting point for estimation of asset returns. There is a large number of articles explaining the workings and

2.2 Asset Allocation Methods

13

implementation process6 . It is worth noting that the Black-Litterman model was originally proposed for low-dimension global asset allocation and the need to ensure positive deﬁniteness of the constructed covariance matrix is still unresolved. It is concluded that even though there are several patches available for the traditional Markowitz model, most of them only address one of it’s problems. It is thus appropriate to search for other alternatives. The parametric portfolio policy (PPP) method introduced in Brandt et al. [2009] (BSCV) might be a revolutionary alternative to the traditional mean-variance approach of Markowitz [1952]. The PPP is computationally simple and provides an interesting perspective in using descriptive variables and thus also giving explanation to why those particular portfolio weights are being selected.

2.2.3

Arbitrage Pricing Theory

The Arbitrage Pricing Theory (APT) in a Markowitz framework Ross [1976a,b] is used as a benchmarking model. The derivation is adapted from Zenios [2005]. By using this model as a benchmark the same information space is used, but the APT is static compared to the PPP model. Now introducing the framework of multi-factor models and following up with the APT.

Multi-factor Model K,

**The return of the th asset is related to the factors through a linear relation
**

K

for

= 1 2

˜ =α +

=1

β ˜ +˜

(2.2)

The variance of the th factor is given by σ 2 and the security-speciﬁc residual term ˜ is assumed to be normally distributed with mean 0 and variance σ 2 . It is assumed that the asset returns are correlated only through their response to

6

See for example [Drobetz, 2001], [He and Litterman, 2002] and [Walters, 2011]

2.2 Asset Allocation Methods

14

the common factors. There are additionally three assumptions that generally follow an introduction to the multi-factor model, they are as follows:

1. The covariance of the asset-speciﬁc residual term with the factors is zero, Cov(˜ ˜ ) = 0 for all , . 2. The covariance of the risk factors is zero, Cov(˜ ˜ )=0, for all = 3. The covariance of the residuals is zero, Cov(˜ ˜ )=0, for all =

The ﬁrst assumption will hold by construction if the model includes suﬃcient number of predictive factors. The second assumption can be made to hold by selecting factors that are uncorrelated. Factors can be made uncorrelated by e.g. the Principal Component Analysis (PCA). The third assumption will hold if suﬃcient factors are incorporated so that any residual term is indeed asset speciﬁc, i.e. not systematic.

Arbitrage Pricing Theory (APT) in a Markowitz Framework

Now deﬁning the Arbitrage Pricing Theory (APT) in a Markowitz Framework. The expected return of the th asset is given by

K

=α +

=1

β

(2.3)

**The variance of the th asset is given by
**

K

σ =

2 =1

β2 σ 2 + σ 2

(2.4)

2.3 PPP Methodology

Now representing the APT in a Markowitz framework

K ω∈Ω

15

min

φ

=1

β2 σ 2 +

=1

σ 2 ω2

K

− (1 − φ)

=1

β (2.5)

αω +

=1

st

=1

ω =1 β =

=1

(2.6) ∀ K

β ω

=1 2

(2.7)

2.3

PPP Methodology

The basic idea behind the PPP is to directly model the portfolio weights in each asset as a function of each asset’s characteristics. This is done by maximizing the investor’s average utility of the portfolio’s return over the sample period. The methodology is given in Brandt et al. [2009] as follows; at each date , there are N number of assets, each having a return +1 from date to + 1. There are also some asset speciﬁc characteristics observed at date . The investor’s problem is to choose the portfolio weights to maximize the conditional expected utility of the portfolio’s return +1 ,

N {

max E

} =1

N

(

+1 ) = E =1

+1

(2.8)

The optimal portfolio weights are parametrized, by θ, as a function of asset characteristics, , = ( ; θ) (2.9) Now substituting the parametrization into Equation (2.8) the conditional optimization can be written as an unconditional optimization problem with respect to θ:

N

max E

θ

(

+1 )

=E

=1

(

; θ)

+1

(2.10)

2.3 PPP Methodology

The sample analog can be written as,

T −1 T −1 N

16

1 max θ T

=0

(

1 +1 ) = T

=0 =1

(

; θ)

+1

(2.11)

There are several points to be made about the model at this point. First, (BSCV) propose a linear portfolio weight function that captures the idea of active portfolio management relative to some benchmark portfolio: = + 1 θ ˆ N (2.12)

where ¯ is the weight of asset at date in some benchmark portfolio, θ is a vector of coeﬃcients to be estimated, ˆ are the asset speciﬁc variables, standardized cross-sectionally to have mean zero and unit variance across all assets at date . This standardisation, is a vital part of the PPP as it implies that the optimal cross-sectional average of θ ˆ is zero, meaning that the deviation of the optimal portfolio weights from the benchmark weights sum to zero, and thus that the benchmark portfolio weights always sum to one. The cross-sectional standardization ensures that the distribution of ˆ is stationary through time, while the raw may be non-stationary. The 1/N term is a normalization that allows for arbitrary and time-varying number of assets in the portfolio weight function. Otherwise doubling the number of assets would result in twice as aggressive allocations.

2.3.1

Estimation and Statistical Inference

The standard Markowitz model is an quadratic programming problem making it easily solvable, by matrix manipulation. The PPP is solved using numerical optimization, that will require some advanced programming to be implemented in an appropriate manner. In order to estimate the error on each parameter Brandt et al. [2009] suggest either to estimate the asymptotic covariance matrix or to use bootstrapping. The bootstrapping is easier to implement in practice. A further discussion on the estimation procedure and inference can be seen in Chapter 4.

2.3 PPP Methodology

Reﬁnements and Extensions

17

One of the strongest components of the PPP is the adaptability of the method to accommodate a large universe of diﬀerent methodologies. The objective function can be change to meet an asset managers preferences, any utility function can be used, diﬀerent performance measures e.g. Sharpe og information ratios can be used. Furthermore, drawdowns can be controlled and minimizing VaR or CVaR in a scenario generation framework. The PPP framework also allows for portfolio weight constraints, time-varying coeﬃcients, shrinkage and easy implementation of transaction costs. Furthermore, the portfolio weight function in Equation (2.12) can take any form, so long as the portfolio weights sum to one.

2.3.2

Literature Review

Focusing again on the pioneering work of Brandt et al. [2009] and the related literture. BSCV choose to use the well-known Fama-French-Carhart - factors book-to-market and size Fama and French [1993] as well as a momentum factor Carhart [1997] as asset characteristics. Finding that for a CRRA utility investor with risk aversion γ = 5, an annualized certainty equivalent gain of 11.1% in sample and 5.4% out of sample based on monthly U.S. data from 1974 to 2002. Also using PPP Hand and Green [2011], who introduce the inﬂuence of three simple, ﬁrm speciﬁc annual accounting characteristics - accruals, change in earnings, and asset growth. They ﬁnd that the accounting characteristics yield an out-of-sample, pre-transactions costs annual information ratio of 1.9 as compared to 1.5 for the standard price-based characteristics of ﬁrm size, bookto-market, and momentum. The performance fails though to be so impressive after introducing transaction costs. Castro [2010] also uses the PPP and incorporates unobserved eﬀects into the portfolio policy function. These eﬀects measure the importance of unobserved heterogeneity for exploiting the diﬀerence between groups of assets. Where the source of the heterogeneity, is locally priced factors, such as industry or

**2.4 Concluding on Asset Management
**

country.

18

By sorting currencies on their interest rate, Roussanov et al. [2008] identify a slope factor in currency returns, driven entirely by common exchange rate variation. The higher the currency’s interest rate, the more the currency is exposed to this slope factor. This suggests that a standard APT can be used to explaining carry trade returns. The loadings on this slope factor line up with the average returns on the currency portfolios. They also show that the forward discount, i.e. the diﬀerences in interest rates between two currencies, is the single most important risk factor in currencies. Barroso and Santa-Clara [2012] use PPP to ﬁnd that the interest rate spread, momentum and reversal create economic value for investors. The resulting optimal portfolio outperforms the carry trade and other naive benchmarks in an extensive 16 year out-of-sample test.

2.4

**Concluding on Asset Management
**

Wide diversification is only required when investors do not understand what they are doing.

“

— Warren Buﬀett

”

To conclude on asset allocation methods it is important to note what asset managers really want. It is universally accepted that they want to maximize returns while minimizing the risk of their investments. Some investors really want to diversify their portfolio while others, e.g. Warren Buﬀett, have pointed out that by greatly diversifying a portfolio they might as well hold the market portfolio. So in order to beat the market portfolio it must come on the cost of diversiﬁcation. From this perspective, it is easy to conclude that investors really want to use their personal view in their investments. From the same perspective it is important to consider the reasoning behind the Black-Litterman model. It is the introduction of uncertainty on the investors views that is of great importance. Furthermore, from the overview of ﬁnancial optimization literature Zenios [2005] it is apparent that scenario optimization

**2.4 Concluding on Asset Management
**

Measureable Risk Risk Assessment Asset Manager Investor Expected distribution of Return & Risk Investor views Scenario generation Model Selection

19

Un-measureable Risk

Preferences

Decision Model

Portfolio Weights

Return

Figure 2.2: Asset Management Process that Incorporates Investor Views

is the way to proceed. By constructing educated guesses on the distribution of likely outcomes for each variable and to construct an optimal portfolio based on a random draw from those variables. Each draw will result in a portfolio return and repeating this process will result in a return distribution. Then instead of maximizing the return and minimizing the variance, a better framework is to maximize the return while minimizing the downside risk of the return distribution. This framework is known as scenario optimization, which frequently uses the VaR og CVaR risk measures as a benchmark. The PPP can be adapted to accommodated the desirable features just described and depicted in Figure 2.2. The PPP limits the asset speciﬁc risk, but misses like most other methods the asset unspeciﬁc risk factors. Another perspective is to limit systematic or asset unspeciﬁc risk factors, this is possible in the Arbitrage Pricing Theory (APT) framework proposed by Ross [1976a] and Ross [1976b]. The real advantage of APT is that it can be used to minimize speciﬁc risk in a Markowitz modeling framework as proposed in Ross [1976c] and Roll and Ross [1980]. The author has a certain feeling that there might be a certain lack of identiﬁ-

2.4 Concluding on Asset Management

20

cation and deﬁnition of risk factors, in the sense how they aﬀect asset returns. There are at least four aspects that have to be considered in asset management, that is whether risk factors are asset speciﬁc or unspeciﬁc and whether they have homogeneous eﬀect on an asset class. Furthermore, is it important to identify whether risk factors are time dependent. Consider some examples, consider ﬁrst the systematic risk of oil, it might be included as an risk factor in a currency APT model, but increasing oil prices might have positive effects on some currencies while having negative eﬀect on others, thus having non-homogeneous eﬀect. Furthermore, consider that the U.S. is becoming increasingly dependent on imported oil, so the eﬀect of oil prices might be time dependent for the U.S. dollar. Failing to identify the diﬀerent aspects of risk factors would result in less eﬃcient limitation of speciﬁc risk factors. As pointed out in Roll and Ross [1995] APT has not had great inﬂuence in practice, it is easy to hypothesise that it might be due to lack of understanding of the model, or that it is both data and development demanding, but nothing can be concluded. It will be interesting to see if the PPP will fall into the same category as APT or if can make an impact on asset management in practice. The author feels that there are clear academic and practical beneﬁts to the PPP that are not matched by other modeling frameworks known to the author.

C

3

Monetary Economics

In this chapter introduces the theory and practical aspects of monetary economics. Section 3.1 gives a short introduction to the basic monetary theory. Section 3.2 discusses monetary policy and Section 3.3 introduces practical monetary economics.

3.1

Monetary Economics Theory

In this section a short introduction to monetary economic theory is presented. It is obvious that such a big topic can not be covered in a short text so the text is only meant as an short recap of the theory. The theory is mostly adapted from the comprehensive textbook of Feenstra and Taylor [2011].

**3.1 Monetary Economics Theory
**

3.1.1 Exchange Rates

22

Currencies can be deﬁned to have three key functions in an economy, it is a – store of value, price unit and a medium of exchange. An exchange rate (E) is the price of some foreign currency in terms of a home currency. The price changes of one foreign currency can be deﬁned as follows: EH/F ↑ when the home country’s exchange rate EH/F rises, the price of one foreign currency goes up in home currency terms and the foreign currency experiences an appreciation. EH/F ↓ when the home country’s exchange rate EH/F falls, the price of one foreign currency goes down in home currency terms and the foreign currency experiences an depreciation.

Assuming that that the Marshall-Lerner condition1 hold the exchange rate eﬀect on trade can be deﬁned as follows: EH/F ↓ when home country’s exchange rate depreciates, home exports become less expensive to foreigners and foreign imports become more expensive. EH/F ↑ when home country’s exchange rate appreciates, home exports become more expensive to foreigners and foreign imports become less expensive.

E I

↑ ↓

E I

↓ ↑

Exchange rates obviously play an important role on trade but the relationship is endogenous i.e. ease of trade also plays an important role in the behaviour of monetary policy makers.

The condition states that, for a currency devaluation to have a positive impact on trade balance, the sum of price elasticity of exports and imports must be greater than 1.

1

**3.1 Monetary Economics Theory
**

3.1.2 Covered Interest Parity, CIP

23

Using no-arbitrage the covered interest rate parity can be derived to be as follows F$/e (1 + $ ) = (1 + e ) (3.1) E$/e where F$/e is the forward exchange rate, $ and e are the nominal interest rates in dollar and euro, respectively. CIP generally holds in normal market conditions, whereas Baba and Packer [2009] show that during the turmoil of the 2007-2008 ﬁnancial crisis, sharp and persistent deviations from the CIP, and associate it with the US dollar funding shortages of non- US ﬁnancial institutions in wake of the crisis. Furthermore, Obstfeld and Taylor [2004] show how the CIP converges into holding after the abolishment of capital controls in the U.K and Germany in the early 1970s.

3.1.3

Uncovered Interest Parity, UIP

**Using no-arbitrage, and considering a more risk loving investor, (1 +
**

$)

= (1 +

$)

E[E$/e ] E$/e

(3.2)

where E[E$/e ] is the expected future spot rate, $ and e are the nominal interest rates in dollar and Euro, respectively. It is observable from the CIP and UIP equations that the forward rate must equal the expected future spot rate E[E$/e ] = F$/e . Manipulating the UIP a useful approximation can be derived, ∆E$/e = $− e (3.3) E$/e The UIP states that the the dollar depreciation is equal to the interest rate diﬀerential between the dollar and the Euro, i.e. higher interest rates in the U.S. than in the Eurozone the no-arbitrage implies that the dollar should depreciate against the Euro, by that interest rate diﬀerential.

**3.1 Monetary Economics Theory
**

3.1.4 Purchasing Power Parity,

24

Given the law of one price, applied on a basket of goods founds the theory of purchasing power parity ( )2 . Deﬁning the relative price of a basket of goods in Europe versus the U.S., US/EUR ;

US/EUR

=

(E$/e PEUR ) PUS

(3.4)

where (E$/e PEUR ) and PUS are the European and U.S. prices of a basket expressed in dollars. holds when the price level in two countries, when expressed in a common currency, are equal or US/EUR = 1.

Relative

Considering inﬂation relative

can be deﬁned as follows: (3.5)

∆E$/e = πUS − πEUR E$/e

the relative implies that the rate of depreciation of the nominal exchange rate equals the inﬂation diﬀerential between the two countries. Dornbusch [1985] surveys the literature and Taylor [2003] picks up from where Dornbusch left oﬀ. The is considered to hold for the long term and to be a useful in explaining exchange rates as shown by Taylor and Taylor [2004] and Rogoﬀ [1996] presents the puzzle i.e. that deviations from are quite persistent.

Quantity Theory of Money Introducing the simple model known as the quantity theory of money, Assume that a rise in nominal income will cause a proportional increase in economic

2 In order to avoid the mixing the Parametric Portfolio Policy (PPP) and the Purchasing Power Parity ( ) a diﬀerent font is used when refering the to the latter one.

**3.1 Monetary Economics Theory
**

activity and, hence, in aggregate money demand. M

Money demand

25

=

L( )

money demand function

× PY

Nominal income

(3.6)

where is the money demand decreasing function in , assumed constant, as L, for simplicity. Where the real money balance can then be deﬁned as, M =L×Y P (3.7)

Deﬁning the fundamental equation of the monetary model of the price level, PUS = MUS LUS × YUS PEUR = MEUR LEUR × YEUR (3.8)

Now using the equation (3.4) for absolute a fundamental equation of the monetary approach to exchange rates. Introducing the money growth rate, µUS = ∆MUS /MUS and growth rate of real income US = ∆YUS /YUS . It is easily shown that the inﬂation rate equals the money supply growth rate minus the real income growth rate. πUS = µUS −

US

πEUR = µEUR −

EUR

(3.9)

Now introducing the newly deﬁned money growth and real income growth in the relative PPP equation (3.5). Using Money supply-demand equilibrium and the rate of depreciation of a nominal exchange rate can be derived as follows, ∆E$/e = πUS − πEUR = (µUS − E$/e

US

) − (µEUR −

US

EUR EUR

) ) (3.10)

= (µUS − µEUR ) − (

Diﬀerential in nominal money supply growth

−

Diﬀerential in real output growth

So the nominal exchange rate can be described as the diﬀerential between the diﬀerentials in nominal money supply growth and real output growth. Rapach and Wohar [2002] ﬁnd evidence in favour of the monetary model of exchange rate determination in the long run.

**3.1 Monetary Economics Theory
**

The Fisher Eﬀect

26

Considering that if the UIP approximation in equation (3.3) and the relative in equation (3.5) hold, then the nominal interest diﬀerential should equal the expected inﬂation diﬀerential.

$

−

e

= πUS − πEUR

(3.11)

This eﬀect named after the prominent American economis Irving Fisher. As this result relies on an assumption of , it is therefore likely to hold only in the long run. The Fisher eﬀect then states that a rise in the expected inﬂation rate in a country will, ceteris paribus, lead to an rise its nominal interest rate.

Real Interest Parity

Considering the Fisher Eﬀect in equation (3.11), it is apparent that subtracting the inﬂation rate (π) from the nominal interest rate ( ) results in the real interest rate ( ). Thus if and UIP hold, then expected real interest rates should be equal across countries. Thus in the long-run all real interest rates should converge to the expected world real interest rate, ∗ ,

∗

=

US

=

EUR

(3.12)

so interest rates can be considered to be reﬂecting the world real interest rate and domestic inﬂation expectations.

∗ $

=

+ πUS

e

∗

=

+ πEUR

(3.13)

Vitek [2005] surveys the empirical literature concerning the predictability of nominal exchange rates using structural macroeconomic models over the recent ﬂoating exchange rate period.

3.1.5

Complete Theory of Exchange Rates

In order to give a complete theory of exchange rates the monetary and asset approaches are uniﬁed. Starting with the monetary approach or the long-

3.1 Monetary Economics Theory

27

run model of the future exchange rate the fundamental equations and the purchasing power parity are used to predict the future exchange rate.

Short-run money market equilibrium

P = US P

EUR

MUS LUS ( $ ) × YUS MEUR = LEUR ( e ) × YEUR E$/e = PUS PEUR

The Monetary Approach

Purchasing power parity

(3.14) It is assumed that forecasts of future money M , real income Y , and nominal interest rates are known. Knowing these the future price levels can be calculated and then the expected future exchange rate. Now considering the asset approach or the short-run model,

Short-run money market equilibrium

P = US P EUR

MUS LUS ( $ ) × YUS MEUR = LEUR ( e ) × YEUR + E$/e − E$/e E$/e

The Asset Approach

**Uncovered interest parity
**

$

=

(3.15) where the nominal interest rates and the spot exchange rate are assumed unknown. There are of course some real interest rates and a spot exchange rate available but calculated interest rates and exchange rates will found a basis for any strategy taken. It is easy to imagine that strategic positions and the size of those positions are formed based on the deviance from the actual interest rates and spot exchange rate and the calculated ones. Even though the the theory is stated as complete is is actually not that complete as the money demand function has to be estimated. Hetzel [1984]

3.2 Monetary Policy

28

shows some functional form estimation techniques whereas Sala-i Martin and Mulligan [1992] gives an econometric approach.

3.2

Monetary Policy

The objective of monetary authorities, i.e. central banks, is to control monetary issues in order to induce economic growth and build the foundation for a stable economy. Central banks do this by managing monetary issues based on the monetary policy taken at each period called a monetary regime. There are few monetary policies available, most are based on the interlinked nominal variables – the money supply, interest rate, price level, and exchange rate. By constraining one of the nominal variables policy makers hope to achieve long-term objectives while having short-term ﬂexibility of the other nominal variables. Policy makers generally agree that low levels of inﬂation is the most novel objective in order to support economic growth. Feenstra and Taylor [2011] provide a comprehensive introducing the diﬀerent monetary policies. F E R Fixed exchange rate policy is one of the most common policy of choice. Consider rearranging the relative in equation (3.5) and anchoring of the nominal exchange rate, πUS = ∆E$/e + πEUR E$/e (3.16)

if no depreciation is allowed it is called a peg and the home inﬂation should be stable and equal to foreign inﬂation. Pegs are also labelled as being soft or hard, soft being policies where some ﬂuctuations in the pegged exchange rate are allowed and hard meaning that no or little ﬂuctuations are allowed. Allowing for some small constant depreciation, called a crawl, home inﬂation will be higher than foreign inﬂation. Allowing for some variation around a target in the exchange rate, called a band, increases the volatility of the home inﬂation. The home currency can be ﬁxed to a single currency or a basket of currencies. The larger the central banks currency reserves the more trustworthy the peg will be presumed.

3.2 Monetary Policy

M

29

A Monetary aggregates or money supply targeting implies holding the money supply growth at a ﬁxed rate, reviewing the fundamental equation, eq. 3.10, πH =

Inﬂation

µH

Money supply growth

−

H Real output growth

(3.17)

ﬁxing the money supply growth, does not ﬁx the inﬂation rate as the real output growth can ﬂuctuate. This will also result in low inﬂation in periods of high growth and high inﬂation in periods of low growth. It is for sure debatable whether this is a desirable result or not, but it is generally argued that this is undesirable scenario. I T be suggested, From the Fisher eﬀect another anchoring variable can πH =

H

−

∗

(3.18)

if the world real interest rate is assumed to be constant the average home nominal interest rate is kept stable, inﬂation can also be kept stable. A central bank will adjust a nominal interest rate based on inﬂation expectations to keep the inﬂation stable in the long term. This is an increasingly popular policy of choice. G S The gold standard is a monetary system where monetary value is ﬁxed such that the exchange rate from home currency for gold is ﬁxed. ∆EH/G πH = + πG (3.19) EH/G where the gold inﬂation can be thought of as the supply growth of gold which is much slower than most money supply growth rates. The gold standard thus has a mixed eﬀect of the ﬁxed exchange rates and money supply targeting monetary systems. Home inﬂation should be low and stable, but as for the ﬁxed exchange rate system the larger the reserve the more credible the gold standard will be. P A mixed policy usually refers to central banks that are supposed to ensure full employment as well as price stability. It is obvious that this is a really diﬃcult task as the tools for ensuring full employment are usually to lower interest rates in order to encourage investments and public spending. The U.S. central bank or the Fed, is forced to work under this dual mandate or mixed policy.

M

3.2 Monetary Policy

Discussion

30

The ﬁxed exchange rate policy and gold standard have the disadvantage that the central bank sacriﬁces monetary policy autonomy, i.e. free control over monetary aggregates. The other monetary policies can be used to dampen the business cycle. Those monetary policies are referred to as either being expansionary or contractionary. Expansionary policy is traditionally used in a recession by lowering interest rates in the hope that easy credit will increase spending and investment, and hence reduce unemployment. Contractionary policy is intended to slow inﬂation in hopes of avoiding the resulting distortions and deterioration of asset values. This monetary policy utilizes the assumption that money supply can inﬂuence economic growth it is important to realize that there are a lot of other factors, including money demand, demography, tax- and government spending policies, foreign business cycles etc. that also inﬂuence economic growth. Dornbusch [1976] theorized about exchange rate overshooting that is that permanently expanding monetary base not only weakens the exchange rate due to the increased monetary base and the temporarily lower interest rates. The exchange rate then only partially appreciates, when interest rates return to their initial level, failing to reach its initial level. Bjørnland [2009] provides empirical evidence of Dornbusch’s theory and furthermore shows that the UIP seems to hold for most parts. There is substantial literature on monetary policy, where the survey of the theory and evidence of monetary policy, by Blinder et al. [2008] is an ideal starting point. Mussa [1986] documents another real-exchange-rate anomaly that industrial countries which switched from ﬁxed to ﬂoating exchange rate regimes experienced dramatic and persistent rise in nominal exchange rate volatility. The volatility increase could not be accounted by changes in domestic price levels, building a foundation for reasoning that the increased volatility is due to speculation. After the recent crisis some economists have been calling for a review of the monetary and ﬁnancial systems, stating the the current system is not working. While some economists have lashed out at the inﬂation targeting and turning their attention to the gold standard, others have been focusing on Irving

3.2 Monetary Policy

31

Fisher’s ideas of full reserve banking versus the current fractional reserve banking. The focus is on the fact that the current system is unsustainable as money is created as interest bearing debt, mostly by privately held banks. The expected world real interest rate should reﬂect on the expectation of world inﬂation and what is the outlook for world prices. It can be argued that there is increased demand from developing nations, there is limited resources and there are central banks running expansionary policies. There are many evidences supporting for increases in prices so that the world inﬂation and nominal interest rate can be expected to rise in the near future.

3.2.1

The Toolbox of Central Bankers

As an insight into the which tools central bankers have in their toolbox and introduction to them follows. The text is adapted from Sarno and Taylor [2001]. I R Interest rates are determined by central banks. This generally refers to interest rates on funds kept at the central bank overnight. Higher interest rates generally strengthens a currency as funds seek towards higher returns. Higher interest rates, though have the adverse eﬀect of reduced investments so that investors may withdraw funds from the country’s stock market, causing the country’s currency to weaken. I Central banks can inﬂuence the market in many diﬀerent ways, they can talk the currency up or down without taking direct measures. Central banks can also directly intervene on open market, by buying or selling, without telling anyone about it. Sterilized intervention is an intervention by a central bank that does not inﬂuence the money supply, whereas non-sterilized intervention does. Nonsterilized intervention aﬀect the exchange rate through purchasing or selling foreign money or bonds with domestic currency. For example, if the aim is to depreciate the exchange rate of the home currency, home central bank could purchase foreign currency bonds. This will cause extra supply of home currency dragging down the home currency price, and the increased demand of the foreign currency will push up foreign currency price. As a result, the exchange rate drops.

S

3.2 Monetary Policy

32

This process has been exercised extensively by Asian export economies to depreciate their home currency value compared to the dollar in order to induce exports. The evidence of the eﬀectiveness of sterilized intervention is mixed. The sterilized intervention has little or no eﬀect on home interest rates, since the level of the money supply has remained constant. However, according to Mussa [1981], sterilized intervention can inﬂuence the exchange rate through two channels: the portfolio balance channel3 and the expectations or signaling channel4 . N I Nonsterilized intervention inﬂuences the exchange rate by inducing changes in the stock of the monetary base which, in turn, induces changes in broader monetary aggregates, interest rates, market expectations and ultimately the exchange rate. Sarno and Taylor [2001] surveys oﬃcial intervention and it’s eﬀectivness. Furthermore, reporting that non-sterilized intervention is eﬀective. E At the time of crisis central bankers have engaged in the unconventional intervention of quantitative easing to stimulate the national economy. Originated by the Japanese central bank Bank of Japan (BOJ) to ﬁght domestic deﬂation in the early 2000s. The BOJ had maintained short-term interest rates at close to zero since 1999, so the impossibility to lower interest rates called for unconventional measures. With quantitative easing, it ﬂooded commercial banks with excess liquidity to promote private lending, leaving them with large stocks of excess reserves, and therefore little risk of a liquidity shortage. The BOJ accomplished this by buying vast amounts of government bonds, asset-backed securities and equities. Similar policies have been used by the United States, the United Kingdom and the Eurozone during the Financial crisis of 2007-2012 under diﬀerent names but with similar purposes. Ugai [2006] and Shiratsuka [2009] examines Japan’s experience of the quantitative easing policy. There is not much literature on the eﬀectiveness of the current QE in the U.S., U.K., Europe and Japan but Joyce et al. [2010] provides an analysis on the eﬀect QE had on the U.K. market and Krishnamurthy

Sterilized intervention will be strengthened by portfolio balancing of other market participants in the same matter as the central bank. 4 Market participants will view exchange rate intervention as a signal about the future stance of policy.

3

Q

3.2 Monetary Policy

33

and Vissing-Jorgensen [2011] evaluate the eﬀect of the Fed’s QE1 and QE2 on interest rates. This will however probably be a popular topic of future research. R Accumulation of foreign currency reserves has risen exponentially over the last 15 years, mostly driven by the accumulation of the export driven Asian economies, especially China and Japan [ECB, 2006]. There are basically two currencies that are kept as reserves and that is the dollar to the greatest extent, accounting for approximately 60%, and the Euro accounting for approximately 25% of known allocation of reserves.5 . Gold is also kept in foreign exchange reserves as a hedge against the dollar. C Capital controls are an extreme action most often taken by governments in the wake of currency crisis. Capital controls restrict or banish free trading of foreign currencies and thus other ﬁnancial assets, e.g. equities and bonds. Edwards [2002] gives great introduction to the literature on capital controls and capital ﬂows in emerging economies.

C

Edison [1993] surveys the eﬀectiveness of central-bank intervention. Whereas, Blinder et al. [2008] surveys the theory and evidence of central bank communication.

3.2.2

History of Currencies

Feenstra and Taylor [2011] provides a long version of the history of currencies, a very short summary follows.

The Gold Standard, 1816-1933

The gold standard was a ﬁxed commodity standard, where participating countries ﬁxed their exchange rates to a physical weight of gold or silver. The

For discussion of reform of the international monetary system see [Moghadam", 2010] and historical statistics Statistics [2012]

5

3.2 Monetary Policy

34

U.S. where a late adopter of the standard and became the standard-bearer, replacing the British pound when Britain and other European countries come of the system with the outbreak of World War I in 1914. Eventually, the worsening international depression led even the dollar oﬀ the gold standard by 1933, which marked the period of collapse in international trade and ﬁnancial ﬂows prior to World War II. During the 1920s, the U.S. government "sterilized" gold in-ﬂows from Europe used to purchase products, in an eﬀort to prevent the U.S. dollar from strengthening and hurting the export economy. This set the stage for the Great Depression, as it caused the money supply of gold in Europe to shrink (deﬂation). Decreasing monetary base.

The Bretton Woods System, 1944-1973

The post-World War II period saw Great Britain’s economy in ruins, its infrastructure having been bombed. The country’s conﬁdence with its currency was at a low. By contrast, the U.S., thanks to its physical isolation, was left relatively unscathed by the war. Its industrial might was ready to be turned to civilian purposes. In the aftermath of the World War II 45 countries attended, at the behest of United States, at a resort hotel in New Hampshire, Bretton Woods, to formulate a new international ﬁnancial framework6 . This framework was designed to ensure prosperity in the postwar period and prevent the recurrence of the 1930s global depression. The Bretton Woods system formalized the U.S. dollar as the new global reserve currency, with its value ﬁxed into gold, with other currencies then ﬁxed but adjustable to the dollar. The other major currencies at that time the British pound, the French franc and the German mark were all pegged to the dollar, with other minor currencies frequently pegged to them, making the vast majority of the world’s currencies ending up, directly or indirectly pegged to the dollar. This "dollar standard" led to the dollar’s rise to prominence, becoming the reserve currency of choice and staple to the international ﬁnancial markets. Furthermore, this led to dollar denomination of commodities most importantly oil. This further strengthened the reserve currency status of the U.S. dollar.

The meeting also laid the foundations for the formation of The International Monetary Fund and the World Bank.

6

3.2 Monetary Policy

After the Bretton Woods era

35

After close to three decades of the Bretton Woods system, the system came to an end due to growing structural imbalance amongst economies, leading to mounting volatility and speculation. The core of the Bretton Woods’ problems were deteriorating conﬁdence in the dollar’s ability to maintain it’s convertability into gold, due to heavy cost of the Vietnam war. Furthermore, there was unwillingness of surplus countries to revalue their exchange rate due to the adverse eﬀect on external trade. A group of European economies tried to preserve a ﬁxed exchange rate system among themselves by founding the European Monetary System (EMS) of monetary cooperation and the pegging mechanism, Exchange Rate Mechanism (ERM) in 1979. In ERM many European currencies were pegged to the German Mark. The United Kingdom faced deﬁcit problems, initiating them to allow the Sterling to appreciate while imposing capital control. Still willing to form some kind of currency union Britain joined the ERM again in 1990, but lasted only for two years as Germany ran tight monetary policy due to the large ﬁscal shock caused by the reuniﬁcation of Germany. This led to the ERM crisis where the British pound and the Swedish krona amongst others suﬀered from an exchange crisis.

Euro currency union

The Europeans persisted on uniﬁcation and ﬁnally on January 1, 2002, the Euro became the oﬃcial currency of 12 European countries7 .

Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain. Since 2002, 9 more countries have adopted the Euro - Andorra, Cyprus, Malta, Monaco, Montenegro, San Marino, Slovakia, Slovenia and Vatican City

7

**3.3 Practical Monetary Economics
**

3.3 Practical Monetary Economics

36

“

3.3.1

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

— Henry Ford

”

In this section the focus is shifted from the theory of monetary economic to the more practical side of monetary economic, introducing the market, actors and market movers.

The Market for Foreign Exchange

The Market The market for currency exchange also called foreign exchange, forex or FX market is not an organized exchange like stock markets, it is an over-thecounter (OTC) market were market participants electronically exchange currencies. The FX market actually consists of two separate markets the spot market and the future market. The spot market has no physical location nor a central exchange, it operates through an electronic network of banks, corporations, and individuals trading one currency for another. The lack of physical exchange enables the FOREX market to operate 24-hours a day from the banking opening hours in New Zealand on Monday to Friday closing-hours in western states of the United States. The future market is a currency future market were standardized contracts of currency exchange are traded. The volume of the future market is small compared to the spot market.

Carry Trade

There is still another way to proﬁt from the diﬀerences in interest rates between currencies, that is by borrow in low yielding currencies to invest in a high yielding one Fama [1984]. From UIP, carry trades should not yield a

3.3 Practical Monetary Economics

37

predictable proﬁt because the diﬀerence in interest rates between two countries should equal the rate at which investors expect the high interest rate currency to depreciate against the low interest rate one. However, for carry trading pairs the high interest rate currency is expected to appreciate against the low interest rate currency due to the selling of the borrowed low interest rate currency and buying interest of high interest rate currency. This is a selffulﬁlling eﬀect as increased demand for carry trades should strengthen the potential for proﬁt-taking. The reverse process is of course also self-fulﬁlling, i.e. the closing of carry trades should weaken the high interest rate currency and strengthen the low interest rate currency. Roussanov et al. [2008] extend the result of Fama [1984] that higher than usual interest rates lead to further appreciation, by showing that investors earn large excess returns simply by holding bonds from currencies with interest rates that are currently high, not only higher than usual. Comparing the UIP and the documented proﬁt opportunities from carry trade shows the heterogeneity of the forward rate.

Actors The actors in the currency market can be categorized as follows; Business and Speculation. Business are basic transactions by the public, corporates and governments made in order to conduct their business. Speculation is a market participation in order to proﬁt from price movements. Speculation is conducted by most other market participants from large banks, to small time speculators. Participant can further be distinguish as being either traders or investors, traders trade in assets for shorter periods whereas investors hold their investments for longer periods. Traders ride waves while investors sail ships.

Transaction Cost Transaction cost is the spread between bid and ask prices. This spread is measured in so called pips which is the smallest historically reported decimal point of an exchange rate. This is four decimal points for most currencies,

3.3 Practical Monetary Economics

38

even though one additional decimal point might be reported. There is great variability in the spread on currency pairs, the dollar is the most actively traded currency and thus generally has the lowest spread. The Euro is the second most traded pair and thus has the second lowest spread on it’s currency pairs, the spread on the retail market can be as low as one pip for the eurodollar and up to approximately 40 pips for minor currencies such as the scandics and up and above 100 pips for more exotic currencies. Galati [2000] documents that volatility and spreads are positively correlated and argues that correlation between trading volumes and volatility to be positive during normal times but negative during periods of stress.

3.3.2

Currency Analysis

It is commonly accepted that there are two methods for forming trading strategies in any market, these being fundamental and technical analysis. The former being based on economic factors while the other is based on price action. Fundamental analysis are more focused on the long-term, whereas the technical analysis are about the short run. Considering the fundamental analysis, exchange rates are a reﬂection of the balance between the supply and demand for a particular currency pair. Monetary policy and the general strength of the economy are the two primary factors that aﬀect supply and demand. The general strength of the economy can be estimated from the following economic factors.

3.3.3

Economic factors

There are a series of economic indicators that are of importance to exchange rates and ﬁnancial markets in general. These economic indicators are republished in so-called economic calenders available by many sources8 . These economic calenders also publish so-called consensus estimates of the economic indicators. The following list of indicators are some of the most important.

8

See for example http://www.forexfactory.com/ or http://www.tradingﬂoor.com/

**3.3 Practical Monetary Economics
**

C

39

A The current account9 is the sum of balance of trade, factor 10 and cash transfer. Current account surplus, the country’s net income international asset position increases correspondingly. Barrios et al. [2009] ﬁnd an important role for the current account in determining risk premia. T The trade balance is the net diﬀerence between the imports and exports of a nation over a certain period. The balance of trade is sometimes divided into a goods and a services balance. A The capital account reﬂects net change in national ownership of assets. Capital account can be broken further into net values of Foreign Direct Investment (FDI), portfolio investments, other investments and reserve account. D P The gross domestic production (GDP) is the total market value of all goods and services produced within an economy. The growth rate of GDP indicates the pace at which a country’s economy is growing, or shrinking. GDP is generally considered to be backward looking, as it reﬂects on how the economy was doing in the past. P Industrial production (IP) is a measure of the change in the production of a nation’s factories, mines, and utilities. IP also considers capacity utilization that is industrial capacity and available resources among factories, utilities, and mines. M I The purchasing managers index (PMI) is a composite index of national manufacturing conditions, reﬂecting purchasing managers’ acquisition of goods and services. PMI is divided into manufacturing and non-manufacturing sub-indices and is generally considered to be a forward looking measure. P I The producer price index (PPI) is a measure of price changes in the manufacturing sector. It measures average changes in selling prices that producers receive for their output. P I The consumer price index (CPI) is a measure of the average price level paid by consumer for a ﬁxed but adjustable basket

B

C

G

I

P

P

C

9 The balance of payments has two primary components, current account being one and the other being capital account. The two components should sum to zero. 10 Factor income is the earning on foreign investments minus payments to foreign investors

3.3 Practical Monetary Economics

40

of goods and services. The CPI basket diﬀers between countries, but is supposed to measure the cost of living and measure changes in price levels or simply inﬂation. D G The durable goods orders indicator measures new orders placed with domestic manufacturers for immediate and future delivery of durable goods. Durable goods being deﬁned as a good that lasts for an extended period of time. I Is a measure of employment but also reﬂects on the spending power in the economy. S Retail sales is an standardized indicator of broad spending patterns and thus implies the real consumer conﬁdence. S Housing starts measures the number of residential construction permits issued each month. Housing starts is sensitive to interest rates and consumer conﬁdence, and has an eﬀect on the general level of employment. Government bond yields are also an important measure for relative strength of currencies, as higher yields will lead to weaker currencies. Bond yields are an immediate measure on the markets perspective on bond yields.

E R H

B

The producer price index, the consumer price index and the gross domestic production are generally considered the indicators that have the biggest immediate impact.

3.3.4

Market Sentiment - The Real Market Movers

Besides the monetary policies and economic factors there are some underlying eﬀects that inﬂuence pricing of currencies. These eﬀects can be summarized as follows. R O /O This is a market phenomenon describing the herding behaviour amongst traders. During a market sentiment of Risk on, the

3.3 Practical Monetary Economics

41

market participants are optimistic and more willing to take risk in exchange for possibly better returns. When the market sentiment is Risk oﬀ, there is pessimism in the market and it will favour perceived lower risk assets. E D Ownership of debt has a huge eﬀect on currencies. Japan is a great example of locally owned debt whereas US has external debt to a much greater extent. The fact that U.S. debt is to some extent external, increases the incentive to devalue the currency as that is also devaluing the debt. Gros and Alcidi" [2011] examines the periphery countries and states that external debt is the key factor in whether economies face solvency problems or not, pointing out that Greece and Portugal have high external debt. R C E The eﬀect of being a reserve currency is a massive eﬀect as it founds a huge demand for that particular currency. If the dollar would lose just a partial of their reserve currency status it will cause a massive depreciation of the dollar. H E During economic uncertainty or downturns investors move their money into assets that are known to preserve their values during an market turmoil. These investments are also often self-fulﬁlling as increased demand will cause prices to rise. The currencies that are genuinely considered to be safe haven currencies are the Japanese yen, Swiss franc and the U.S. dollar. B E Major movements to and from particular regions or countries can lead to large ﬂuctuations in exchange rates. This eﬀect is also self-fulﬁlling as a movement out of a particular market can cause the currency of that economy to weaken, due to selling interest, and thus trigger a further selling of that market. E The Manufacturing sector in each economy beneﬁt from weaker home currency and thus it is easy to see that net exporting nations beneﬁt from weaker currency. To limit the negative eﬀect on trade by their currency appreciating against the dollar Japan and China, along with several other developing countries in Asia, sought to peg or control their exchange rates to limit their appreciation against the dollar.

S

P

T

3.4 Technical Analysis

42

The weakening of the Euro in the summer of 2012 sparked life into the economic discussion on who was going to lead the world economy out of the current crisis and how. Weaker Euro shifted the attention to the fact that the U.S. was not particularly up for a prolonged period of strong dollar compared to the Euro, so further QE followed. It is easy to suggest that it was done in order to weaken the dollar and hoping that it would enhance economic growth. It is though diﬃcult to see that there is any sustainability in that growth. It is maybe worth referencing Barro [1974] where he argues that every bond-ﬁnanced deﬁcit must be met by a future tax increase. Furthermore will the loose monetary policy of the Federal Reserve11 force other large central banks to partially loosen up their own monetary policy if they do not what their home currency to appreciate against the dollar. It is thus easy to suggest that globally looser monetary policy will eventually lead to a greater world inﬂation.

3.4

Technical Analysis

Technical analysis are mainly used by traders in order to ﬁnd good entrance and exit points. There are really many diﬀerent technical analysis available but to name a few; Moving Average, Relative Strength Index (RSI) and Moving Average Convergence/Divergence (MACD). Technical measures only use an assets own asset price development to spot changes in the strength, direction, momentum, and duration of a trends in asset prices. As they have no economic value there will be no further discussion of them, but there is a bulk of textbooks on technical analysis available.

11 The Federal Reserve System is the central banking system of the United States, also known as the Fed.

C

4

Methodology and Data

In this chapter the methodology of the analysis is given a comprehensive description. It shows how the modeling procedures where implemented and should make the reading of the programming code much easier. Furthermore, the data used in the analysis are presented. Section 4.1 describes the modeling and inference methodologies in an accessible manner. Section 4.2 describes the optimal set of data and presents the actual set of data.

4.1

Methodology

Now the modeling process will be given a step-by-step description. This will be a more practical orientated discussion whereas the more elegant mathematical description is given in Section 2.3. The whole modeling process can be sectioned into three main processes; data process where the data are handled, modeling process where the modeling

4.1 Methodology

44

steps are taken and the result process where the results are handled. First, is the data process. 1. Import Data. The data consist of N asset returns, , and M descriptive variables, X , spanning time T . Data are described in Section 4.2. 2. Data Manipulation, data are manipulated such that they are ready for modeling. As an example for GDP, there are GDP ﬁgures for all economies, ﬁrst diﬀerence is calculated in order to make the variable independent of the economies size. All data manipulations are speciﬁed in Section 4.2. 3. Standardization, each of the M descriptive variable groups, X , is ˆ standardized by a non-conventional standardization, X being a standardized descriptive variable group. The standardization is done crosssectionally by subtracting the row mean at time of that variable group and then dividing by the row standard deviation.1 4. Specify initial optimization conditions. These include initial parameter values, θ0 , utility parameter, γ, shrinkage parameter λ and the number of bootstrapping iterations B. 5. Specify initial benchmark weights, . It is important to note the importance of the benchmark portfolio in the PPP framework, it could be the market index if equities where the asset class under consideration. There is no market index in currencies but aggregate market positions for large market participants are available once a week and could serve as benchmark weights2 . Second, is the modeling process. There are three diﬀerent modeling processes considered and presented in Section 4.1.1, but they all contain the following processes. ˆ 6. From the design matrix containing all the standardized variables, X ,

1 A subtraction by row median could be considered as well as a way to account for potential outliers. 2 Saxobank publishes a great weekly report on the topic on tradingﬂoor.com. See CFTC’s website for the orginal data.

4.1 Methodology

ˆ an asset speciﬁc design matrix, X ˆ and X is of size (T × ) 7. Portfolio weights are calculated by, = + 1 ˆ X θ N ˆ is created. X

45

is of size (T × )

(4.1)

where θ is a ( × 1) vector of parameter estimates. The result from ˆ X θ is thus a (T × ) × ( × 1) = (T × 1) matrix of variable driven deviations from the benchmark portfolio. 8. Portfolio returns are calculated by the following formula,

N +1

=

·

+1

anlong with the standard deviation of the portfolio returns. 9. Utility from returns is calculated. The standard CRRA utility function is used along with a shriking of estimated parameters. The utility function is then as follows (1 + )1−γ 1 )= −λ· · 1−γ M

M

(

θ2

(4.2)

where γ is the utility parameter and λ is the shrinkage parameter. The shrinkage is done in order to prevent unnecessary variable inﬂation, especially in the bootstrapping process3 . 10. Optimization of estimation parameters θ is done with the Nelder-Mead optimization procedure. The Nelder-Mead does not handle single variable optimization, hence the Brent optimization procedure is used for single variable models. These methods were chosen as they do not require a gradient function, the disadvantage is though that it is not possible to conclude that the optimum is a global optimum. Diﬀerent initial conditions were tried in order to get some conviction that optimal values were indeed a global optimum, with satisfactory results.

3

Further discussion in Section 4.1.2

4.1 Methodology

46

Implementing an manual estimation of the gradient and the Hessian matrix would enhance the modeling procedure and make it possible to access whether the optimization results are the global maximum or just a local one. Furthermore it would allow for the asymptotic estimation of standard errors of parameter values. The estimation of gradient and the Hessian matrix where not conducted in this thesis due to the limited time frame. Third, is the result processing 10. Annualization of return and standard deviations are calculated. The annualization is done by multiplying the returns by the frequency, , and the standard deviation by the square root of . The frequency is 4 for quarterly data, 12 for monthly data and 252 for daily data. From the average annualized returns and standard deviation the Sharp ratio is calculated as follows ˜ Sharp Ratio = ˜ σ 11. Inference by bootstrapping, the bootstrapping process is given a thorough description in section 4.1.2. 12. Calculate out-of-sample performance. The out-of-sample performance is examined by a 10-fold cross-validation.

4.1.1

Diﬀerent Modeling procedures

As economic factors are published with diﬀerent frequencies it would be extremely practical to be able to utilize them in decision making. It is of course possible to implement this in numerous diﬀerent procedures. The focus will be on three diﬀerent modeling procedures that are presented as follows.

P1: Simple Regression like Modeling Process

The ﬁrst modeling process can be seen in Figure 4.1. In this process quarterly

4.1 Methodology

47

Figure 4.1: Simple Regression like Modeling Process P1.

and monthly data are extracted such that they are on the same format as the daily data. The advantage with this modeling method is its simplicity whereas it might be possible to get better results by using diﬀerent modeling procedures.

P2: Stepwise Modeling Process

The stepwise modeling process was inspired by the interesting feature of the benchmark weights in the weight function, Equation 2.12. With the initial quarterly benchmark weights set as the equally positively weighted portfolio, the output of the quarterly model is then extracted such that it can be used as the monthly benchmark weights. The same extraction of the monthly weights to the daily benchmark weights help produce the ﬁnal daily portfolio weights. It is the hope that the stepwise modeling process would produce better results, than the simple regression like modeling process, P1.

P3: One Step Modeling Process.

It is then easy to see that optimizing the same process in one step could provide even better results. The gain would come from adjustments in quarterly parameters resulting in lower quarterly returns but higher daily and thus aggregate return.

4.1 Methodology

Data

Data(Q) Data(M) Data(D)

48

Quarterly

WM

Monthly

WD

Daily

Process Results

Results

Figure 4.2: Stepwise Modeling Process P2.

Figure 4.3: One Step Modeling Process P3.

4.1.2

Statistical Inference

In order to estimate the error on each parameter Brandt et al. [2009] suggest either to estimate the asymptotic covariance matrix or to use bootstrapping. The asymptotic covariance matrix is much more evolved as it requires the gradient and the Hessian of the utility function with respect to θ. Statistical inference is thus conducted by bootstrapping.

4.1 Methodology

Bootstrapping

49

Bootstrapping is a wide ﬁeld of resampling methods for diﬀerent purposes within statistics and applied mathematics4 . Here nonparametric bootstrapping is considered, meaning that the obtained data are treated as an accurate reﬂection of the parent population. Repeated samples are drawn, with replacement, from a pseudo-population consisting of the obtained data. Due to special characteristics of time series, they are often subjected to more advanced bootstrapping methods. Goncalves and Politis [2011] reviews those methods, but here the focus will be on normal bootstrapping and block bootstrapping. Block bootstrapping is probably the easiest of these methods to implement, even though there are numerous variations, one selects stretches of time series, either overlapping or not and of ﬁxed length or random, i.e. whatever that can guarantee stationarity in the samples. The block length must increase with increasing sample size to enable the block bootstrap to achieve asymptotically correct results, according to Härdle et al. [2003]. It is also important to note that bootstrapping small samples requires special attention5 . The reason for this is that the inference from bootstrapping is dependent on the number of observations. As an example consider modeling some landscape ﬁrst with very few data points and then again with a great number of observations, with the same model. Bootstrapping the samples the resulting picture of how that landscape looks like is by no mean related to the quality of the model it is only dependent on the number of data.

Application 1. The appropriate bootstrapping method, normal or block, is selected and then whether it is a single- or multi-factor model due to the diﬀerent optimization algorithms. 2. Draw B independent bootstrap samples X1 X1 XB from population

3. The optimization is done B number of times and the parameter estimates are saved for all instances.

4 5

See, e.g. Efron and Tibshirani [1993] for more on bootstrapping See e.g.Tanaka [1987]

4.1 Methodology

50

4. The standard error of parameter estimates is calculated by the following equation given in Efron and Tibshirani [1993],

B 1/2

ˆ (θ) = ˆ where θ ∗ =

1 B B ˆ =1 θ

1 B−1

ˆ ˆ θ − θ∗

=1

(4.3)

4.1.3

Benchmark

The Arbitrage Pricing Theory (APT) in a Markowitz framework Ross [1976a,b] is used as a benchmarking model. The mathematical description is given in Section 2.2.3, whereas the following description is a more applied one. The derivation is adapted from Zenios [2005] and extended to ﬁt the current setting with asset speciﬁc factors.

Modiﬁed APT Model

In order for the usage of asset speciﬁc factors in the APT model the following modiﬁcations are suggested. The expected return in Equation 2.3 will changed to

K

=α +

=1

β

(4.4)

in order to allow for asset speciﬁc factors. The variance of the th asset will the be given by

K

σ2 =

=1

β2 σ 2 + σ 2

(4.5)

where the factor variance, σ 2 , is now also asset speciﬁc. The factor variance is now a matrix but there is actually no fundamental change. The factor variance vector is actually just asset speciﬁc just like the parameter estimates. Now

4.1 Methodology

restating the modiﬁed optimization problem

K ω∈Ω

51

min

φ

=1

β2 σ 2 +

=1

σ 2 ω2

K

− (1 − φ)

=1

β (4.6)

αω +

=1

st

=1

ω =1 β =

=1

(4.7) ∀ K

β ω

=1 2

(4.8)

Reviewing the conditions for the ﬁrst condition is unaﬀected as it only considers if the model ﬁt is good enough and it should actually be better with asset speciﬁc variables. The second condition is also unaﬀected as it is fulﬁlled by the PCA6 . This makes it very easy to calculate the covariance in the mean-variance analysis, as all oﬀ-diagonal elements are zero. The third and the last condition is furthermore also unaﬀected as it states that their can be no systematic eﬀect left in the residuals. This could be more probable as there is no modeling of say risk on/oﬀ behaviour of investors, but hardly to a signiﬁcant degree if numerous factors are considered.7

Application

The ﬁrst two steps of the APT method are the same as for the PPP in Section 4.1 so the modeling process can be described as follows. 3. Specify initial optimization conditions. These include initial parameter values, ω0 , and a risk aversion parameter, φ.

6 Principal components are guaranteed to be independent only if the data set is jointly normally distributed. There are though numerous ways around this is the data are far from being jointly normally distributed 7 An oversight of a big systematic risk factor would cause a deviation in both the covariance and return terms in the objective function.

4.2 Data

52

4. From the design matrix containing all the variables an asset speciﬁc design matrix, X is created. 5. Conduct a Principal Component Analysis (PCA) on the asset speciﬁc descriptive variables, X to get . Normally this would just be done once, but is done here for each asset speciﬁc design matrix. 6. Calculate the factor variance,σ 2 , of each principal component for all assets. The factor variance forms the ﬁrst part of the variance part of the objective function, Equation 4.6. 7. Regress the asset speciﬁc principal components, . Done for each asset. , on asset returns,

8. Calculate the predicted values, ˆ , from the regression of the principal components on asset returns. The predicted values form the return part of the objective function after being multiplied with the portfolio weights, ω 9. Calculate the error variance, σ 2 , from each regression. The error variance forms the second term in the variance part of the objective function. 10. Calculate the Objective function by collecting the terms in notes 6. 8. and 9. The constraint that portfolio weights should sum to one is multiplied by a large constant so that it is fullﬁlled the last constraint is redundant as it is already applied in the objective function. 11. Optimization is carried out numerically with the Nelder-Mead algorithm. 12. Calculate the returns as follows, = N · that the APT returns static portfolio weights. , and it is noticeable

Returns and standard deviation are annualized and the model performance is validated by 10-fold cross-validation.

4.2

Data

In this section the optimal set of data is discussed and then data are given a thorough description.

4.2 Data

4.2.1 Optimal set of Data

53

Deﬁning the optimal set of data requires a deﬁnition on what the goal is in the beginning. In order to test and implement the PPP a limited set of variables is suﬃcient, as can be seen from the fact that both Brandt et al. [2009] and Hand and Green [2011] show superior performance relative to their benchmarks using only three variables. The goal of this thesis is to implement and analyse the asset management process using the PPP as a modeling method on a portfolio of currencies. So the data requirements for this objective is just a complete set of data for a number of the most traded currency crosses. An optimal set of descriptive data would contain a complete set of all variables imaginable that inﬂuence currencies. The horizon of the analysis would depend on the accessibility of data, in the sense that using yearly data spanning a ten year period would not leave many observations. The challenge of having diﬀerent frequency data and given the signiﬁcance of low frequency data play a part in the data selection.

Horizon

The horizon of the analysis also depends on the purpose. If the objective is to invest or to rebalance a portfolio at a central bank, low frequency data should be suﬃcient. Estimates of future values of economic indicators could then be used in a strategic evaluation of future proﬁt taking. If the objective is to proﬁt from trading, i.e. short term proﬁt taking, more high frequency data are required both in the dependent and independent variables. These data are really hard to come by, as those who possess these data know that a good modeling framework could extract proﬁts from price movements leaving less on the table for themselves. It is also worth mentioning that the PPP could be an ideal framework for automatic trading strategies where the time frame is really short and solely based on models using technical analysis along with some fundamental analysis. The PPP furthermore uses a cross-sectional standardization, which calls

4.2 Data

54

for attention on behalf of the modeller that the variables are suitable for standardization in the sense that the data have to be economically comparable and in a numerically similar range.

Data quality

Data quality is vital for a good analysis, no matter whether the focus is on causality or model performance. A survey conducted by Barra [2011] shows that asset managers value data quality as the single most important factor in model performance.

Potential Variables

There are numerous variable that could be interesting to try in the current framework. The variables from Section 3.3.3 and the eﬀects from Section 3.3.4 are ideal candidates. It would be wise to incorporate both lagged and forward looking variables. There is simple plenty of other variables that could be created, such as Risk On/Oﬀ variable, by e.g. high positive correlation of JPY and CHF and negative with the other currencies in a risk oﬀ season. It would also be wise to try to determine whether currencies are in an trending phase or ranging. Creating such variables and using some powerful data mining tool, CART regression should also help create additional value. There are also few variables in [Barroso and Santa-Clara, 2012] that are not considered here.

4.2.2

Data Resources

Data are extracted from the Thomson Reuters DataStream database Thomson Reuters [2012] spanning the twenty year period from 26/06/1992 to 27/06/2012. Data where extracted on the 28/06/2012. Data where validated through comparison with other data resources; e.g. central bank webpages, the World Bank database and the external wealth of nations database by Lane and Milesi-Ferretti [2001].

4.2 Data

Exchange Rates

55

Currency under consideration will be G10 currencies USD, EUR, JPY, GBP, CHF, CAD, AUD, NZD, SEK, NOK. The reason behind selecting these currencies is two-folded. First, these are the ten most liquid currencies on ﬁnancial markets, in the order they are presented8 . Currencies that are frequently traded also have lower transaction costs. Second, is the fact that these are the currencies that have the most complete set of descriptive data. Nine currency crosses from the ten currencies form the exchange rates that are used to calculate currency returns. The exchange rates can be seen in Figure 4.4. The U.S. dollar (USD) is used as the foreign currency i.e. inverse of the U.S. exchange rate are used, e.g. E /$ . Returns are then continuously compounded.

Descriptive Variables

There are numerous economic factors that could serve as descriptive variables and the variables selected here are those who had complete data series for all economies under consideration. The PPP requires that all the descriptive variables are asset speciﬁc i.e. that they are directly related to that speciﬁc asset. This creates a problem that an economically meaningful variable can not be used if there are no observations for one of the economies under consideration. Graphical representation of the descriptive variables can be seen in Appendix A.

Quarterly Data

The main economic indicators Gross Domestic Production (GDP) and Current Account (CA) are presented quarterly. These are also presented with a delay as the ﬁgures take considerable time to be estimated. Foreign Reserves positions are also considered as a descriptive variable and they are released

8 Deutsche Bank has popular currency funds and one focusing on the G10 with 2:1 leverage. See www.dbfunds.db.com

4.2 Data

Quarterly Exchange Rates

JPY AUD CAD EUR NOK. NZD SEK CHF GBP

56

Quarterly Exchange Rates

0.6

1992

0.8

1.0

1.2

1.4

1.6

1994

1996

1998

2000

2002 Year

2004

2006

2008

2010

2012

Figure 4.4: Quarterly Exchange Rates Returns from Q3-1992 to Q2-2012. Data are centered to the ﬁrst observation

quarterly by central banks. Now considering expected signs of the quarterly variables; GDP [+] A positive sign is expected, as rise in GDP is likely to strengthen the conﬁdence of market participants. Foreign Reserves [+/−] Rising foreign reserves would add to conﬁdence that a central bank can maintain currency stability. This would particularly apply for ﬁxed exchange rate regime currencies and small ﬂoating currencies. Considering the eﬀect on large economies is more diﬃcult to predict, e.g. the foreign currency holding of the U.S. is very minimal and the Euro-area has been decreasing their reserves for quite some time while Japan has huge reserves. The conclusion can be drawn that the eﬀect is maybe not even homogeneous for all the economies under

4.2 Data

57

consideration. It can thus be concluded that it is not suﬃcient to have asset speciﬁc variables they also need to have homogeneous eﬀects on the currencies. The eﬀect of increase in foreign reserves is expected to be positive in general. Current Account [+] A current account surplus for an economy should results in a stronger currency as it represents net wealth transfer into the economy.

Monthly Data

There are numerous economic indicator available on monthly bases. Ten year bond yields, consumer price Index (CPI) and M2 money supply were chosen as some of the most import ones. There is of course other indicators that could have been used as well, but were made redundant due to missing data or other problems in making them useful. Now considering expected signs of the monthly variables; Bond yields [−] A negative eﬀect is expected as higher yields mean that it is more expensive for the economy to ﬁnance it’s debt. M2 [+/−] It is not simple to predict the eﬀect of the M2 money supply. Increasing money supply should induce growth in economic activity meanwhile it decreases the value of money if there are greater amounts of them available, thus positive and negative eﬀects respectively. Increase in money supply is generally expected to be positive in the short term. Furthermore, there is the Keynesian medicine that at the time of crisis the monetary base should be expanded in order to dampen the crisis. The increased monetary supply should have an negative eﬀect while if there is any positive eﬀect of the monetary expansion on the economy the increased economic activity should have a positive eﬀect. Monetary expansions at the time of crisis could decrease the observed positive eﬀect, whereas the positive eﬀect might be delayed. CPI [+/−] CPI or the ﬁrst diﬀerence of the CPI should have an inverse U eﬀect of currencies. That is increasingly positive eﬀect up to some level and then a decreasingly negative eﬀect after that level is reached.

4.2 Data

58

The positive eﬀect comes from the economic conclusion that a growing economy should experience some inﬂation while the inﬂation is nothing but a depreciation of currency value and when inﬂation gets to high it starts having disruptive eﬀects on the economy, negative real interest rates and an increased risk of a credit crunch. The level can easily be argued to by changing with time and even diﬀerent for diﬀerent economies.

Daily Data

For daily data technical data are used as no complete set of high quality, economically meaningful, data were available for the desired modeling period. Hence, the deviations from current exchange rates and the 21 day, 55 day and 200 day Moving Averages (MA), respectively, where used along with the Relative Strength Index (RSI). Moving Averages [−] The moving averages are all expected to have a negative eﬀect as they are supposed to catch reversals or corrections. RSI [−] The momentum oscillator should have negative eﬀect as high values indicate selling might be a good idea and low values buying opportunities.

Data Manipulation

Now describing the data manipulation process for each variable. GDP For the GDP it is actually the rate of change in the GDP that is used. This is readily available and it is from the GDP estimated using the expenditure approach. Current Account Raw CA ﬁgures are denominated in home currency so CA is manipulated by dividing by GDP which is also home currency denominated. That leaves a usable CA that is independent of the economies size. Having CA that can be positive and negative for all the ten

4.2 Data

59

economies, creates a problem when the relative ratio of the current accounts is desired. Dividing the CA would result in un-meaningful ﬁgures so absolute diﬀerences are used, i.e. the U.S. CA is subtracted from the other nine economies CA. Reserves Reserves are denominated in Standard Drawing Rights (SDR) and are divided by GDP in order to make them independent of the size of the economies and then multiplied by the exchange rate to make them all in the same currency SDR/USD. There are few problems with this variable as the U.S holds a very limited reserves whereas Japan has huge reserves and Swiss reserves have been piling up after 2008. Whereas it is possible to calculate the relative ratio here it is still opted to use the absolute diﬀerence, which could be thought of as the U.S. being a benchmark of how little reserves an economy could hold. The rate of change in the reserves was not tested but it might actually be more meaningful. Bond yields The ten year bond yield is a good measure of economic health that is actually available on a daily bases but is not easily available at that frequency. The absolute diﬀerence is used for the bond yields as for most of the other variables. CPI The ﬁrst diﬀerence of CPI is calculated and then the absolute diﬀerence instead of relative ratio. Money Supply As a measure of money supply the M2 money measure is used. The ﬁrst diﬀerence of money supply is used and as before absolute diﬀerence is used instead of a relative ratio. Moving Averages The standard 21 day, 55 day and 200 day moving averages are calculated for each asset. Then as the PPP requires compatible data the relative deviation from current exchange rate was used. Moving averages are calculated as the average of the past observations. RSI The RSI is calculated for each asset and used as it is. RSI is an extremely popular momentum indicator. The RSI is calculated as follows, RS = EMA(U EMA(D ) ) (4.9)

4.2 Data

60

where EMA is the exponential moving average and is the exponential smoothing factor. The U and D are calculated from the data as follows, U= D= ∆ 0 0 ∆ if ∆ >0 otherwise otherwise if ∆ <0 (4.10)

(4.11)

The Relative Strength Index can then be calculated as follows, R SI = 100 − 100 1 + RS (4.12)

As can be seen the RSI is a scale with the neutral value being 50, so low values are indicate that there might be a buying opportunity whereas high values signal a potential selling opportunity.

From the description of the data and the data manipulation it is clear that there is great room from improvement within this area. Reﬂecting that variable selection was not the main focus of this thesis.

4.2.3

Limitations of the Analysis

To conclude on the limitation of the methodology they are quite a few given the limited development time for a thesis.

Limitations

As the implementation of the PPP took considerable time, some simpliﬁcations were made in the analysis.

1. Interest Rate Diﬀerential (IRD) is ignored. IRD is the proﬁt/loss from net interest rate diﬀerentials in currency crosses. IRDs can be considered as dividend like returns whereas they can in fact also be negative.

4.2 Data

61

2. There is no riskless rate implemented, i.e. it is set at zero. There are two reasons for this, ﬁrst the investor can take his desired positions in bonds and on retail accounts. If trading in bonds they are subjected to currency risks as bonds are denominated in some currency. Secondly, the investor can choose whether he has a retail account with or without speciﬁc calculations of IRDs. If the investor is carry trading he would choose a market maker that returns IRDs. 3. Data quality is poor. Better data would provide more intuitive results. Due to this data manipulation and variable selection were given limited time frames. 4. More advanced optimization framework would provide greater conﬁdence in the results. 5. Better estimates of standard error is vital in order to conduct reliable variable selection. Which methodology would be used, the asymptotic variance estimation or bootstrapping is non-important. 6. Transaction cost was not implemented into the model even though it is extremely simple in the PPP model. Barroso and Santa-Clara [2012] actually get better out-of-sample returns after having implemented transaction costs. 7. The Benchmark model was not modiﬁed to by dynamic. That would be required in order to get an appropriate comparison of the two methods. Furthermore, was their little eﬀort made in validating the modeling process of the APT model, i.e. to see if regressions of returns gave good results and so forth.

C

5

Modeling Results

In this chapter the most important ﬁndings of the development process of the PPP are presented. The development process is given a full description in Chapter 4. The ﬁndings are presented in an order of signiﬁcancy. Section 5.1 summarizes the results whereas the general results are presented in Section 5.2

5.1

Summary of Results

The main results of the analysis are plotted in Figure 5.1. Considering ﬁrst the diﬀerent return and standard deviations of each currency cross the CHF, NZD, JPY and AUD are all in similar range, they have the highest return and standard deviations. The Scandics, NOK and SEK have similar volatility but signiﬁcantly lower return. The GBP and EUR have approximately zero return over the twenty year period. The CAD then has a positive return while having the lowest standard deviation. Now considering the model performances, the Markowitz model was used to

5.1 Summary of Results

Mean Variance Analysis

PPP Efficient Frontier

63

Markowitz Efficient Frontier

0.03

0.04

Mean Annualized Return

PPP IS PPP OOS

Markowitz IS

0.02

CHF APT OOS APT IS CAD NOK SEK GBP EUR JPY NZD AUD

−0.02

0.00

−0.01

0.00

0.01

0.05

0.10

0.15

Annualized Standard Deviation

Figure 5.1: Mean Variance Analysis with Eﬃcient Frontiers.

plot the eﬃcient frontier and was furthermore one of the models under consideration along with the APT and PPP. The in-sample(IS) performance of the Markowitz model can be quite good and is close to the eﬃcient frontier which is constructed using the whole dataset. The out-of-sample (OOS) of the Markowitz model is though out of the charts as it either hits or misses i.e. it results in either great or abysmal returns due to its extreme and informationless portfolio weights. The performance of the APT model is much more stable but the return is maybe not extremely good but still quite good considering that it is a static model, i.e. uses the same portfolio weights in the test sample. The OOS of the APT is has rather extreme portfolio weights but does not result in as extreme portfolio performance as the Markowitz model does. The PPP has of course much greater return but it has to be considered that it is a dynamic model

5.2 General Results

64

and thus has a great competitive advantage. The OOS of the PPP is worse than the IS performance An eﬃcient frontier for the PPP was constructed by altering the utility parameter, γ, values from being very risk averse to very risk loving1 . The P1 modeling procedure were used for the PPP.

5.2

5.2.1

General Results

Comparison of Modeling Procedures

The comparison of the parameter values and model performance of the three modeling procedures; P1, P2 and P3, that were introduced Section 4.2.1 can be seen in Table 5.1. Furthermore, Model (P1* ) uses the P1 modeling procedure with the extracted monthly benchmark weights from Model (P2) as a benchmark weight. This is done to show the eﬀect of benchmark weights on the model. First, checking on the sign of the parameter values it can be seen that the sign on the foreign reserve (Res) and 10y bond yields (bond) have opposite signs in diﬀerent models i.e. they are both positive in Models (P1) and (P1* ) and negative in Models (P2) and (P3). This result is maybe not so surprising at least not for the foreign reserves variable as there was a certain doubt about the sign of the eﬀect. The result for the bond yield is more surprising and it is hypothesised that it is due to some heterogeneity of the bond yield eﬀect. On the comparison between observed and expected signs, Models (P2) and (P3) comply the best to the signs that were expected. The results for Model (P2) are discussed further in Section 5.2.2. On the performance of the diﬀerent procedures the P1 and P2 perform similarly whereas the P3 outperformed them quite signiﬁcantly. The benchmark portfolios play a vital role in the performance of the PPP method as can be seen by comparing the model performance for Models (P1) and (P1* ). Similar hikes in performance where observed for the other models such as the P3, when quality benchmark portfolio weights where used, even though it is not reported. This has led to the conclusion that the P3 modeling procedure resulted in the best performance and furthermore that the best performance is observed when extruded modeling results from modeling procedure P2 were

1

Utility parameter values, γ, from 0.001 to 200

5.2 General Results

used as benchmark weights.

65

Further considering the model performance, Figure 5.2 shows the cumulative returns of the four models under consideration. It is apparent that Models (P1) and (P1* ) perform really well after crisis whereas Models (P2) and (P3) are more stable performers.

Cumulative Return of the Different Modeling Procedures

P1 P2 P3 P1*

Cumulative Return of the Different Modeling Procedures

0.0

1992

0.2

0.4

0.6

0.8

1994

1996

1998

2000

2002 Year

2004

2006

2008

2010

2012

Figure 5.2: Cumulative Return of Diﬀerent Modeling Procedures.

5.2.2

Results for P2

Considering ﬁrst the quarterly variables, the results can be seen in Table 5.2. Model (1) is the equally weighted portfolio, where all portfolio weights are set at equal amounts and kept throughout the modeling period. The equal weights were chosen as positive meaning that the portfolio consist of short postition in the USD and equally long in all others. The average annualized return is

5.2 General Results

P1 GDP st.err. Res st.err. CA st.err. bond st.err. m2 st.err. cpi st.err. ma21 st.err. ma55 st.err. ma200 st.err. RSI st.err. Ave. Ret. Sd. Sharpe 3.362 3.342 1.241 2.591 3.400 2.847 2.223 6.052 4.707 2.958 2.484 3.266 -1.446 3.790 -0.284 4.111 -1.911 4.884 -4.683 5.546 .0415 .0498 .8328 P2 0.669 0.548 -0.401 0.644 0.889 0.422 -1.450 2.692 1.948 2.492 1.036 2.400 -1.497 3.162 0.098 3.812 -0.498 2.294 -1.827 3.144 .0366 .0439 .8323 P3 1.466 2.369 -0.080 2.558 2.922 2.875 -1.209 3.176 3.692 3.049 3.823 2.179 -0.372 2.889 -0.832 2.424 -0.427 2.867 -4.073 3.761 .0373 .0415 .8982 P1* 7.971 4.209 0.760 5.137 3.014 6.478 2.301 4.473 3.425 6.878 1.828 4.752 -11.785 5.804 2.791 5.312 -1.951 5.767 -3.143 6.112 .0412 .0451 .9143

66

Note: Model (P1*) is modeling procedure P1 with different benchmark weights. The variables under consideration are GDP (GDP), Foreign Reserves (Res) and Current Account (CA), 10y Bond yield (Bond), M2 Money Demand (M2) and Current Account (CPI), 21day moving average (MA21), 55-day moving average (MA55 ), 200-day moving average (MA200) and relative strength index (RSI). Ave Ret is the average annualized return, Sd is the annualized standard deviation and Sharpe is the Sharpe Ratio.

Table 5.1: Results for diﬀerent modeling procedures.

5.2 General Results

67

positive and serves as a benchmark for the other models as these positively equally weighted portfolio weights are the benchmark portfolio weights in the other models.

(1) GDP st.err. Res st.err. CA st.err. Ave. Ret. Sd. Sharpe .0028 .0364 .0768 (2) 0.225 0.282 -0.077 0.333 0.170 0.275 .0044 .0258 .1699 .0028 .0314 .0886 .0042 .0334 .1266 .0046 .0261 .1770 (3) (4) (5) 0.403 0.540 -0.066 0.518 (6) 0.406 0.373 -0.221 0.543 0.340 0.618 .0042 .0278 .1529 (7) (8) 0.669 0.538 -0.401 0.540 0.889 0.474 .0077 .0210 3693

0.441 0.388 .0066 .0234 .2842

Note: The variables under consideration are GDP (GDP), Foreign Reserves (Res) and Current Account (CA). Model (1) is the equally weighted portfolio. Ave Ret is the average annualized return, Sd is the annualized standard deviation and Sharpe is the Sharpe Ratio. Utility parameter γ = 5 and shrinkage parameter λ = 001.

Table 5.2: Results for Quarterly data from modeling process P2.

Models (2) through (4) consider the modeling power of single variables, and each variable increase the Sharpe ratio whereas the foreign reserves is the variable which improves the return the least, compared to the benchmark return. Models (5) through (7) then consider pairs of variables. Combining foreign reserves with GDP and current account, in Model (5) and (7) respectively, results in little better results whereas the combination of GDP and current account, in Model (6), boosts the Sharpe ratio signiﬁcantly. Model (8) considers all variables and results in the best performance. Now considering the sign of parameter values and comparing them with the predicted eﬀects which can be seen in Section 4.2.1. Starting with the GDP the realized sign is positive as predicted. Next considering the sign of foreign reserves (Res) it has negative sign whereas the predicted sign was generally positive. Hypothesising why, it might be due to the currencies of the large economies, U.S., Japan and the Eurozone, not beneﬁting from holding increased foreign reserves. Considering the standard errors in Table 5.2 it is clear that there is not

5.2 General Results

68

a single parameter estimate statistically signiﬁcant, the parameter estimate would have to be at least twice as large as the standard error (st.err.) in order for the parameter estimates to be signiﬁcant. This result will be discussed further in Section 5.2.3. Now the monthly variables are considered, the results can be seen in Table 5.3. Model (9) is a model free of variables but considers the extracted quarterly weights as the benchmark weights. It is apparent that the positive return from the quarterly modeling is transferred through and results in positive monthly returns. Models (10) through (12) consider the modeling power of single variables, and each variable increases the Sharpe ratio signiﬁcantly. Models (13) through (15) consider pairs of variables and there is a good harmony between the variables in Model (13) whereas there is little gain in Model (14) and worse performance in model (15). Finally, considering all variables together in model (16) resulting in the best performance so far. Considering the sign of parameter values, starting with the bond yields the observed sign is negative which ﬁts the expected negative sign. Next observing that there is a positive sign for the M2 money supply there is a positive sign indicates that the induced economic growth by increased money supply outweighs the negative eﬀect of increased money supply, at least in the short term. Finally, considering the ﬁrst diﬀerential of CPI it is generally expected to be positive which aligns with the observed sign.

5.2 General Results

(9) Bond st.err. M2 st.err. CPI st.err. Ave. Ret. Sd Sharpe .0131 .0520 .2519 (10) -0.145 1.325 0.727 1.502 0.326 1.403 .0145 .0470 .3086 .0172 .0395 .4354 .0169 .0440 .3849 .0209 .0388 .5381 (11) (12) (13) -0.705 2.244 1.242 2.255 (14) -0.015 1.917 0.249 1.558 0.610 1.789 .0179 .0450 .3966 (15) (16) -1.450 3.388 1.948 2.112 1.036 2.275 .0244 .0396 .6175

69

0.650 2.087 .0170 .0440 .3851

Note: The variables under consideration are 10y Bond yield (Bond), M2 Money Demand (M2) and Current Account (CPI). Model (1) is the equally weighted portfolio. Ave Ret is the average annualized return, Sd is the annualized standard deviation and Sharpe is the Sharpe Ratio. Utility parameter γ = 5 and shrinkage parameter λ = 0001.

Table 5.3: Results for Monthly data modeling process P2.

The results for the daily variables can be seen in Table 5.4. Model (17) is the benchmark model using the monthly portfolio weights and it is apparent that most of the performance from the monthly model is transferred though to the daily returns. Models (18) through (21) consider the modeling power of single variables, and each variable increases the Sharpe ratio signiﬁcantly. The performance of the shorter horizon moving averages are better than the longer ones. Models (22) through (25) consider pairs of the moving averages variables and it is apparent that two of them would have been suﬃcient whereas there is no gain in having them all three, as can be seen from model (25). Model (26) considers all of the daily variables resulting in a good performance, but not as good as considering only RSI as in Model (21). Considering the signs of the daily variables a negative sign was expected on all of the variables and negative signs are also observed, except for MA55 in model (26) which might indicate that it is over-driven to have three moving averages variables.

5.2 General Results

(17) MA21 st.err. MA55 st.err. MA200 st.err. RSI st.err. Ave. Ret. Sd Sharpe (18) -0.899 0.805 -0.630 0.852 -0.458 1.102 -0.946 1.104 (19) (20) (21) (22) (23) (24) (25) (26) -1.497 3.143 0.098 3.158 -0.498 2.693 -1.827 3.294

70

-1.464 -1.521 -2.259 1.945 1.527 2.834 -0.355 -1.154 -0.292 1.941 1.685 2.538 -0.378 -0.107 -0.457 2.104 2.153 2.779

.0225 .0360 .0314 .0275 .0357 .0361 .0363 .0313 .0364 .0366 .0409 .0458 .0454 .0454 .0420 .0458 .0460 .0455 .0463 .0439 .5508 .7861 .6914 .6052 .8490 .7877 .7891 .6892 .7865 .8323

Note: The variables under consideration are 21-day moving average (MA21), 55-day moving average (MA55 ), 200-day moving average (MA200) and relative strength index (RSI). Model (1) is the equally weighted portfolio. Ave Ret is the average annualized return, Sd is the annualized standard deviation and Sharpe is the Sharpe Ratio. Utility parameter γ = 5 and shrikage parameter λ = 00001.

Table 5.4: Results for Daily data from modeling process P2.

Currency and Period Speciﬁc Results

Table 5.5 presents the modeling results of Model (26) dissected into shorter periods and currency speciﬁc results. Starting at the lower end of table it can be seen that the Euro (EUR) is the only currency that has negative returns over the modeling period. This indicates that the Euro-dollar exchange rate is the most diﬃcult currency cross to model and it is generally accepted to be the currency cross that is most aﬀected by news. The Australian Dollar (AUD) is also has rather poor performance which might be caused by the fact that it is really popular in the carry trade, but this is purely a hypothetical guess. The British pound (GBP) it the single currency cross that has the best performance over the modeling period. Now considering the right most columns in Table 5.5 it seems that the model performance is somewhat stable over the whole modeling period with the exceptions of the 1995-1996 and 2005-2006 periods. The best performances are in the 1993-1994, 2001-2002 and 2009-2012 periods. This is quite an interesting result as it is not that the model breaks down at the time of crisis

5.2 General Results

but rather results greatest returns over and after economic crisis2 .

Periode 1993-1994 1995-1996 1997-1998 1999-2000 2001-2002 2003-2004 2005-2006 2007-2008 2009-2010 2011-2012 Ave. Ret. St. Dev. Sharp Ratio

71

JPY AUD CAD EUR NOK NZD SEK CHF GBP Portfolio .0125 -.0329 .0079 .0002 .0143 .0102 .0108 .0141 .0119 .0049 .0048 .0106 -.0059 .0193 -.0116 .0079 -.0033 -.0085 .0084 .0008 .0059 .0077 .0053 .0066 .0010 -.0062 .0055 -.0019 .0038 .0081 .0033 .0026 -.0033 -.0155 .0065 .0005 -.0015 -.0092 -.0055 -.0025 .0087 .0139 .0004 -.0071 .0038 -.0173 .0120 -.0138 .0179 .0279 .0018 -.0041 .0193 .0218 .0149 -.0054 .0012 .0201 .0069 -.0088 .0216 .0121 .0082 .0013 .0066 -.0021 -.0121 .0075 -.0101 .0159 .0053 .0028 -.0067 .0008 .0045 .0320 -.0008 .0237 .0127 -.0273 .0055 .0016 .0091 .0045 .0158 .0192 -.0033 .0039 .0106 .0005 .0695 .0143 .0344 .0319 .0558 .0388 .0085 .0360 .0567 .0195

.0053 .0023 .0034 -.0025 .0040 .0073 .0044 .0056 .0069 .0366 .0186 .0155 .0103 .0095 .0158 .0218 .0165 .0166 .0105 .0439 .2860 .1462 .3322 -.2670 .2505 .3326 .2662 .3353 .6572 .8323

Note: Reportet results are the average annualized returns.

Table 5.5: Currency and period speciﬁc results from Model (26).

5.2.3

Bootstrapping Results - Standard error

Considering the standard error estimates it is easy to see that no variable is signiﬁcant. The reason for that is the problem with inﬂation of parameter estimates in the bootstrapping process. In the implementation process of the bootstrapping methods it was observed that for approximately 30% - 40% of samples, parameter estimates were really high compared to the general trend of parameter estimates and they even shifted signs. There are few plausible reasons for this, ﬁrst, the samples are quite small, especially for the quarterly and monthly data. Then there is the fact that the data are time series meaning that autocorrelation could be an issue. Last but not least their is obvious endogeneity in many of the variables. Barroso and Santa-Clara [2012] conduct a similar analysis as done in this thesis but get very robust estimates, this might be due to more quality data or alternative leads to the suggestion that there could be some unobserved error in the bootstrapping procedure.

2

The 1992 European currency crisis, 2001 dot-com bubble and ﬁnancial crisis of 2008.

5.2 General Results

72

There is a lot of literature on bootstrapping methods for time series and the reason being that they are quite tricky to bootstrap. Most bootstrapping methods depend heavily on the assumption that the sampling sample is large. Many of the bootstrapping methods for time series are heavily evolved but the simple one, block bootstrapping, which is applied here does not seem to produce stable estimates. There is some literature on small sample estimation, but the samples used here would probable be deﬁned as very small. It is thus not possible to read much out of the standard errors even though they can be considered as somewhat indicative of how stable the estimates are. This leads to the question whether the PPP can be used to say something about causality. Castro [2010] incorporates unobserved eﬀects into the portfolio policy function, incorporating unobserved eﬀects could improve the stability of parameter estimates. The implementation of parameter shrinkage could not stop the parameter inﬂation. A better modeling procedure could provide better results, so even though the results here might indicate that the PPP is not suitable for theorizing about causality, this is not the conclusion drawn by the author due to the fore-mentioned reasons.

C

6

Conclusion

This chapter contains a short summary of results found in the thesis, in Section 6.1. Suggestions on possible further work related to the work done in this thesis are discussed in Section 6.2.

6.1

Summary of Results

On the asset management subject it has been shown that currencies play a major role on ﬁnancial markets as it eﬀects all asset classes directly, indirectly or through currency denomination. Furthermore considering all the deﬁciencies of the Markowitz model, suggest that maybe it is time to give the traditional Markowitz model some rest and pursue with other methods. The performance of the PPP model is benchmarked to the Markowitz model and the Arbitrage Pricing Theory (APT). The PPP outperformed the benchmark models but the PPP is a dynamic model whereas the others are static. The PPP was documented to have robust in-sample and out-of-sample performance. The importance of how to best model data of diﬀerent frequencies

6.2 Further Work

74

was shown. Furthermore the importance of the benchmark portfolio weights was shown. Most of the variables under consideration performed as expected, whereas the foreign reserve eﬀect seemed to be heterogeneous and the bond yields seemed to be plagued with heterogeneous eﬀects as well. There is considerable implementation cost to the PPP and the procedure does also require complete sets of high quality data. Standard error estimates were observed to be great, suggesting that either an improved estimation procedure or better data were required. It is concluded that the PPP model is attractive in an economic sense as was able to attain a Sharpe ratio of 0.91 with limited focus on variable selection. This is a similar Sharpe ratio as attained in Brandt et al. [2009] where equities are the asset class under consideration. Given the fact that retail markets for currencies allows for quite signiﬁcant leverage it seems to be possible to implement a proﬁt machine1 . Furthermore, it is concluded that the PPP could lead to advances in academic research on how ﬁnancial markets work in practice. Increasing the general knowledge of how currency markets work could result in better monetary policies.

6.2

Further Work

Variable selection seem as an obvious next step to the analysis done in this thesis. There are numerous variables that are not considered here that could result in an much better results and furthermore provide crucial knowledge on what drives currency returns. This would not just serve as proﬁt machine but also provide fundamental new knowledge of how currency markets work in reality. On the variable selection process the following process is suggested. Use asset speciﬁc parameters θ for each descriptive variable and compare them with the single variable θ for that particular descriptive variable. This should be easy to implement and could help in ensuring that a variable has a homogeneous eﬀect in explaining returns. Time-varying parameter could just as well be implemented.

1

Retail accounts provide leverage from 200x up to 500x.

6.2 Further Work

75

Then maybe more crucially is the fact that only asset speciﬁc variables can be considered. This limits the set of variables that can be considered as descriptive variables. The following process is a suggestion on how unspeciﬁc variables could be included. By regressing both asset speciﬁc variables and asset unspeciﬁc variables onto the real eﬀective exchange rate of each currency under consideration. Each factor would then be decomposed into real eﬀects. Those eﬀects could then be used in the PPP framework. Divide variables into asset speciﬁc variables and asset unspeciﬁc variables, and then calculate the asset speciﬁc eﬀect that the asset unspeciﬁc variable has on the asset. Considering for example the currency unspeciﬁc variable, oil, it would be possible to estimate the asset speciﬁc eﬀect of that risk factor. The decomposed eﬀects would be subjected to estimation error. In order to improve the performance it would also be wise to use consensus of economic indicators and select a good benchmark. Furthermore, incorporating views into the modeling framework, i.e. by conducting scenario optimization. It would also be wise to classify currency pairs into a carry trade portfolio, momentum that is emerging market currencies and value currencies that could be benchmarked by the performance of the similar Deutche Bank funds. It is likely that diﬀerent factors would explain the returns for diﬀerent currency classes.

APT

In order to make the APT competitive with the PPP it would have to be made dynamic. This could probable be done in numerous ways but the following solution is suggested. Observations would be given decaying weights such that the newest weights would have the highest weights and the older ones diminishing weights. This should result in dynamic portfolio weights and the decaying parameter would in turn control how dynamic the model would be. It would also be interesting to see whether the idea behind the PPP could improve the APT as the cross-sectional standardization seems to be well suited in explaining returns. This can be explained by the negative and

6.2 Further Work

76

positive values that are the result of the standardization and maybe easier to understand that strictly positive variables can not result in both positive and negative returns given that they are multiplied by a constant, θ. An interesting extension to the APT model would be to do the orthogonal transformation not along the axis that has the greatest variance but rather along a predetermined risk factor. Say if an asset manager were to foresee a speciﬁc risk, e.g. a burst of an asset bubble, he could adjust his portfolio by minimizing that speciﬁc risk out of his portfolio or maximizing his position against the risk event.

A

A

Data Appendix

A.1

Exploratory Data Analysis

In this section the exploratory data analysis is conducted and documented. The following are the most obvious observations. From Figure A.1 it can be seen that the JPY and NZD are quite volatile. The SEK has the greatest depreciation following the 1992 ERM crisis. From 2002 to 2008 the U.S. dollar experienced quite the depreciation which shows up as an appreciation mor most of the other currencies. It is also interesting to notice the correlation of the JPY and CHF during the ﬁnancial crisis of 2008 ans all the other currencies depreciate they appreciate, most probable due to their safe-haven status. Considering next the Quarterly correlations in Figure A.2 it is apparent that the JPY has low correlation with most of the other currencies except for the AUD and CHF. The JPYAUD is a popular carry trade pair and the JPY and CHF are both safe-haven currencies. The GBP also has low correlation with the other currencies with most of the other currencies. The AUD and CAD are heavily correlated as both economies are heavily dependent on natural

A.1 Exploratory Data Analysis

78

resources. Economies that are geographically close to each other also usually have higher correlations. Now considering the GDP in Figure A.3 it can be seen that the GDP is generally positive with Japan struggling the most to maintain economic growth. The ﬁnancial crisis of 2008 hit most of the economies quite hard but they also recovered quite quickly. Considering the correlations of GDP in Figure A.4 it is apparent that the U.S., U.K and Eurozone economies that have the highest correlations. This might be interpreted as the world economy. Now considering the foreign reserves in Figure A.5 it is noticeable that the U.S. reserves is almost non-existence in comparison with the other economies. Furthermore, that the smaller economies hold greater proportion of their GDP as currency reserves. Most noticeable in the great accumulation of foreign reserves by CHF in the 2009-2012 period caused by heavy buy demand of the CHF due to uncertainty in ﬁnancial markets in the aftermath of the 2008 crisis. The current account as a ratio of GDP can be seen in Figure A.6. The small wealthy economies of Swiss, Norway and Sweden have the highest ratios, whereas the Australian and New Zealand have the lowest ratios. Japan has a pretty stable and positive current account. The 10 year bond yields can be seen in Figure A.7. It is interesting to note how interest rates have been lowering for the past twenty years. Sweden has lowered their bond yields from over 10% to under 2%. It is interesting to note the low interest rates for the prolonged period from 2011 to date. It represents the extreme pessimistic prospects of ﬁnancial markets. The consumer price index can be seen in Figure A.8. It shows how Japan has been struggling with deﬂation and interestingly shows that Australia and the U.S. have had the greatest inﬂation of the economies under consideration. Considering the M2 money supply in Figure A.9 shows that the AUD has had the greatest increase in money supply over the observation period.

A.1 Exploratory Data Analysis

79

**Monthly Exchange Rates
**

JPY AUD CAD EUR NOK. NZD SEK CHF GBP

Monthly Exchange Rates

0.6

1992

0.8

1.0

1.2

1.4

1.6

1994

1996

1998

2000

2002 Year

2004

2006

2008

2010

2012

Figure A.1: Monthly Exchange Rates Returns from Q3-1992 to Q2-2012. Data are indexed to the ﬁrst observation

A.1 Exploratory Data Analysis

80

**Monthly Exchange Rates
**

0.5 0.9 1.0 1.4 0.4 0.7 0.6 1.0 1.1

JPY AUD

0.71

0.5

0.9

0.61

1.0 1.4

0.52

0.84

0.83

**EUR NOK. NZD SEK CHF GBP
**

0.18

0.29

0.7

0.57

0.93

0.78

0.82

0.83

0.88

0.4

0.38

0.70

0.6 1.0

0.80

0.91

0.86

0.84

0.87

0.85

0.71

0.15

0.37

0.46

0.56

0.58

0.53

0.58

0.7

1.1

0.7

1.0

0.12 0.18

0.10

0.18

1.4

1.8

Figure A.2: Correlation of Monthly Exchange Rates for the period Q3-1992 to Q22012.

1.4

1.8

0.10

0.88

0.89

0.77

0.12

0.53

0.89

0.87

0.96

0.20

0.7

0.90

CAD

1.0

0.7

A.1 Exploratory Data Analysis

81

GDP

GDP

0

5

Japan Australia Canada Euro Norway New.Zealand Sweden Switzerland U.K. U.S. 1992 1994 1996 1998 2000 2002 Year 2004 2006 2008 2010 2012

−5

Figure A.3: GDP from Q3-1992 to Q2-2012.

A.1 Exploratory Data Analysis

82

GDP

1 3 5

Japan

−4

2

−2

4

−2

2

−4

2 5

1 3 5

Australia

0.27

Canada 0.45 0.45

2

Euro

0.62 −4

0.38

0.80

Norway

0.35

0.56

0.45

0.52

4

New.Zealand

0.53

0.49

0.55

0.43

0.57 2 8

Switzerland U.K. 0.46 U.S. 0.41

−2

Sweden

0.62

0.34

0.79

0.86

0.37

0.44

2

0.46

0.17

0.53

−2

0.76

0.27

0.12

0.68

6

0.65

0.63

0.75

0.77

0.61

0.72

0.70

2

0.58

0.62

0.81

−4 2 6

0.74

−2

0.62

0.55

0.68

−6 2 8

0.84

−6 0 6

−4

−5

5

4

Figure A.4: Correlation of GDP from Q3-1992 to Q2-2012.

−6

0

−6

−2

4

−4

2 6

−5

A.1 Exploratory Data Analysis

83

Foreign Reserves as a Ratio of GDP

1.5

Foreign Reserves as a Ratio of GDP

0.0

0.5

1.0

JPY AUD CAD EUR NOK NZD SEK CHF GBP USD

1992

1994

1996

1998

2000

2002 Year

2004

2006

2008

2010

2012

Figure A.5: Foreign Reserves from Q3-1992 to Q2-2012. It is apparent that smaller economies hold larger proportions of their GDP in foreign reserves.

A.1 Exploratory Data Analysis

84

**Current Account as a Ratio of GDP
**

JPY AUD CAD EUR NOK NZD SEK CHF GBP

Current Account as a Ratio of GDP

−0.10

1992

−0.05

0.00

0.05

0.10

0.15

0.20

0.25

1994

1996

1998

2000

2002 Year

2004

2006

2008

2010

2012

Figure A.6: Current Account as a ratio of GDP from Q3-1992 to Q2-2012.

A.1 Exploratory Data Analysis

85

10y Bond Yields

10y Bond Yields

4

6

8

10

JPY AUD CAD EUR NOK NZD SEK CHF GBP USD 1992 1994 1996 1998 2000 2002 Year 2004 2006 2008 2010 2012

2

Figure A.7: 10 Year Bond Yields from Q3-1992 to Q2-2012.

A.1 Exploratory Data Analysis

86

Consumer Price Index

1.7

JPY AUD CAD EUR NOK. NZD SEK CHF GBP USD

Consumer Price Index

1.0

1992

1.1

1.2

1.3

1.4

1.5

1.6

1994

1996

1998

2000

2002 Year

2004

2006

2008

2010

2012

Figure A.8: Consumer Price Index from Q3-1992 to Q2-2012.

A.1 Exploratory Data Analysis

87

**M2 Money Supply
**

JPY AUD CAD EUR NOK NZD SEK CHF GBP USD

M2 Money Supply

1

1992

2

3

4

1994

1996

1998

2000

2002 Year

2004

2006

2008

2010

2012

Figure A.9: M2 Money Supply from Q3-1992 to Q2-2012.

A

B

Programming

In this chapter a brief introduction is made on the programming proceedings. All programming was performed in the statistical software R. A brief discussion about the software can be seen in Section B.1.

B.1

The R Language

R is a programming language and environment for statistical computation and software development. R’s main strengths lie in statistical and time-series analysis, whereas it can also be used in general matrix calculations. R also has great data manipulation abilities, and ﬁne graphical facilities. R is a great environment for statistical software development whereas it is highly ﬂexible in programming new functions. R objects can be manipulated by the programming language C and for computer intensive tasks C, C++ and Fortran code can be linked and called at run time, making R particularly practical for model development. R can also be used from within Microsoft

B.2 R code

89

Excel. The R language is one of the most widely used statistical software amongst statisticians1 . R is an open source program made available by the R Development Core Team [2007]2 . The term open source means that it is free of charge and all programs are written by active practitioners. In order to give credit to the writers of the additional packages, used in the programming process of this thesis, a brief notation about the packages follows, with citations for further informations.

B.2 R code

In order to recreate the results presented in this thesis the following procedure should be executed. Set directory, load data and run functions in QuickStart.r then run the CombinedModelRun.r and MeanVarPlot.r. Code appendix is omitted but all code is available up on request. For data and code requests please send e-mail to arnar.einarsson@gmail.com.

1 2

Along with it’s commercial twin sister S-PLUS. For further informations see R’s homepage:http://www.r-project.org/¸

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