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Technical Analysis in The Foreign Exchange Market: A Layman's Guide
Technical Analysis in The Foreign Exchange Market: A Layman's Guide
Christopher J. Neely is an economist at the Federal Reserve Bank of St. Louis. Kent A. Koch provided research assistance.
T
echnical analysis, which dates back a technical analysis in foreign exchange
century to the writings of Wall Street (and other) markets, economists have tra-
Journal editor Charles Dow, is the use of ditionally been very skeptical of its value.
past price behavior to guide trading deci- Technical analysis has been dismissed by
sions in asset markets. For example, a some as astrology. In turn, technical
trading rule might suggest buying a currency if traders have frequently misunderstood
its price has risen more than 1 percent from what economists have to say about asset
its value five days earlier. Such rules are price behavior. What can the two learn
widely used in stock, commodity, and (since from each other? This article provides
the early 1970s) foreign exchange markets. an accessible treatment of recent research
More than 90 percent of surveyed foreign on technical analysis in the foreign
exchange dealers in London report using exchange market.
some form of technical analysis to inform
their trading decisions (Taylor and Allen,
1992). In fact, at short horizons—less than A PRIMER ON TECHNICAL
a week—technical analysis predominates ANALYSIS IN FOREIGN
over fundamental analysis, the use of other EXCHANGE MARKETS
economic variables like interest rates, and
prices in influencing trading decisions. Technical analysis is a short-horizon
Investors and economists are interested trading method; positions last a few hours
in technical analysis for different reasons. or days. Technical traders will not hold
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Figure 1
existence of trends: Trends in motion tend
to remain in motion unless acted upon by
Peaks, Troughs, Trends, Resistance another force. The third principle of tech-
and Support Levels Illustrated for nical analysis is that history repeats itself.
the $/DM Asset traders will tend to react the same
$ per DM way when confronted by the same
0.72 conditions. Technical analysts do not
claim their methods are magical; rather,
0.70 Resistance level they take advantage of market psychology.
0.68 Sell signal from a Following from these principles, the
0.5% filter rule methods of technical analysis attempt to
0.66 Local troughs
identify trends and reversals of trends.
0.64 Trendline These methods are explicitly extrapolative;
Local peak that is, they infer future price changes
0.62 Buy signal from a 0.5% filter rule from those of the recent past. Formal
Support level methods of detecting trends are necessary
0.60
May June July Aug Sept because prices move up and down around
1992 the primary (or longer-run) trend. An
NOTES: Not all buy and sell signals from the filter rule are identified. example of this movement is shown in
Figure 1, where the dollar/deutsche mark
($/DM) exchange rate fluctuates around an
positions for months or years, waiting apparent uptrend.2
for exchange rates to return to where fun- To distinguish trends from shorter-run
damentals are pushing them. In contrast, fluctuations, technicians employ two types
fundamental investors study the economic of analysis: charting and mechanical rules.
determinants of exchange rates as a basis Charting, the older of the two methods,
for positions that typically last much involves graphing the history of prices
longer, for months or years. Some traders, over some period—determined by the
however, use technical analysis in practitioner—to predict future patterns
conjunction with fundamental analysis, in the data from the existence of past
doubling their positions when technical patterns. Its advocates admit that this
and fundamental indicators agree on the subjective system requires the analyst to
direction of exchange rate movements. use judgement and skill in finding and
Three principles guide the behavior interpreting patterns. The second type of
of technical analysts.1 The first is that method, mechanical rules, imposes consis-
market action (prices and transactions tency and discipline on the technician by
volume) “discounts” everything. In other requiring him to use rules based on mathe-
words, all relevant information about an matical functions of present and past
1
asset is incorporated into its price history, exchange rates.
These principles and a much
so there is no need to forecast the
more comprehensive treatment
fundamental determinants of an asset’s
of technical analysis are provid-
value. In fact, Murphy (1986) claims that Charting
ed by Murphy (1986) and
Pring (1991). Rosenberg and asset price changes often precede observed To identify trends through the use of
Shatz (1995) advocate the changes in fundamentals. The second charts, practitioners must first find peaks
use of technical analysis with principle is that asset prices move in and troughs in the price series. A peak is
more economic explanation. trends. Predictable trends are essential to the highest value of the exchange rate
2
Figure 1 shows only closing
the success of technical analysis because within a specified period of time (a local
prices. In this, it differs from they enable traders to profit by buying maximum), while a trough is the lowest
most charts employed by tech- (selling) assets when the price is rising value the price has taken on within the
nical traders, which might show (falling), or as technicians counsel, “the same period (a local minimum). A series
the opening, closing, and daily trend is your friend.” Practitioners appeal of peaks and troughs establishes downtrends
trading range. to Newton’s law of motion to explain the and uptrends, respectively. For example, as
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example, many technical analysts assign a the investment with the higher expected
special role to round numbers in support return. While the U.S. and German
or resistance levels. When the exchange interest rates are known, the bank must
rate significantly crosses the level of 100 base its decision on its forecast of the rate
yen to the dollar, that is seen as an indica- of appreciation of the DM. If market par-
tion that further movement in the same ticipants expect the return to investing in
direction is likely.4 Other prominent types the German money market to be higher
of technical analysis use exotic mathemat- than that of investing in the U.S. money
ical concepts such as Elliot wave theory market, they will all try to invest in the
and/or Fibonacci numbers.5 Finally, German market, and none will invest in
traders sometimes use technical analysis of the U.S. money market. Such a situation
one market’s price history to take positions would tend to drive down the German
in another market, a practice called inter- return and raise the U.S. return until the
market technical analysis. two were equalized. The excess return on a
German investment over an investment in
the U.S. money market (Rt DM), at date t,
EFFICIENT MARKETS AND from the point of view of a U.S. investor is
TECHNICAL ANALYSIS defined as
Technical analysts believe that their
methods will permit them to beat the (1) RtDM ; itDM + D St – it $,
market. Economists have traditionally been
skeptical of the value of technical analysis, where itDM is the German overnight interest 4
“The 100 yen level for the dol-
affirming the theory of efficient markets rate, D St is the percentage rate of apprecia- lar is still a very big psychologi-
that holds that no strategy should allow tion of the DM against the dollar overnight, cal barrier and it will take a few
investors and traders to make unusual and it$ is the U.S. overnight interest rate.7 tests before it breaks. But once
returns except by taking excessive risk.6 If market participants cared only about the you break 100 yen, it’s not
expected return on their investments, and going to remain there for long.
if their expectations about the change in the You’ll probably see it trade
Investing in the Foreign exchange rate were not systematically wrong, between 102 and 106 for a
Exchange Market the expected excess return on foreign while,” said Jorge Rodriguez,
To understand the efficient markets exchange should equal zero, every day. director of North American
hypothesis in the context of foreign The assumption that market partic- Sales at Credit Suisse, as
reported by Creswell (1995).
exchange trading, consider the options ipants care only about the expected return
5
open to an American bank (or firm) that is too strong, of course. Surely, participants Murphy (1986) discusses Elliot
temporarily has excess funds to be invested also care about the risk of their investment.8 wave theory, Fibonacci num-
overnight. The bank could lend that money Risk can come from either the risk of default bers, and many other technical
in the overnight bank money market, on the loan or the risk of sharp changes in concepts.
known as the federal funds market. The the exchange rate, or both. If investing in 6
Samuelson (1965) did seminal
simple net return on each dollar invested the German market is significantly riskier theoretical work on the modern
this way would be the overnight interest than investing in the U.S. market, investors theory of efficient markets.
rate on dollar deposits. The bank has other must be compensated with a higher expected 7
The excess return may also be
investment options, though. It could return in the German market, or they will considered the return to some-
instead convert its money to a foreign cur- not invest there. In that case, the expected one borrowing in dollars and
rency (e.g., the deutsche mark), lend its excess return would be positive and equal investing those dollars in
money in the overnight German money to a risk premium. The expected risk- German investments.
market (at the German interest rate) and adjusted excess return would be equal 8
Market participants may be
then convert it back to dollars tomorrow. to zero. That is, concerned about the liquidity
This return is the sum of the German of their position as well as
overnight interest rate and the change in (2) E[RtDM] – RPt = 0, the expected return and risk.
the value of the DM. Which investment Liquidity is the ease with which
should the bank choose? If the bank were where E[*] is a function that takes the assets can be converted
not concerned about risk, it would choose expected value of the term inside the into cash.
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brackets [*] and RPt is the risk premium How do prices move in the hypothetical
associated with the higher risk of lending efficient market? In an efficient market,
in the German market. profit seekers trade in a way that causes
prices to move instantly in response to new
information, because any information that
Efficient Markets makes an asset appear likely to become
The idea that the expected risk-adjusted more valuable in the future causes an
excess return on foreign exchange is zero immediate price rise today. If prices do
implies a sensible statement of the efficient move instantly in response to all new
markets hypothesis in the foreign exchange information, past information, like prices,
context: Exchange rates reflect information does not help anyone make money. If
to the point where the potential excess returns there were a way to make money with little
do not exceed the transactions costs of acting risk from past prices, speculators would
(trading) on that information.9 In other employ it until they bid away the money to
words, you can’t profit in asset markets be made. For example, if the price of an
(like the foreign exchange market) by asset rose 10 percent every Wednesday,
trading on publicly available information. speculators would buy strongly on Tuesday,
This description of the efficient markets driving prices past the point where anyone
hypothesis appears to be a restatement of would think they could rise much further,
the first principle of technical analysis: and so a fall would be likely. This situation
Market action (price and transactions could not lead to a predictable pattern of
volume) discounts all information about rises on Tuesday, though, because specula-
the asset’s value. There is, however, a subtle tors would buy on Monday. Any pattern in
but important distinction between the effi- prices would be quickly bid away by market
cient markets hypothesis and technical participants seeking profits. Indeed, there
analysis: The efficient markets hypothesis is considerable evidence that markets often
posits that the current exchange rate adjusts do work this way. Moorthy (1995) finds
to all information to prevent traders from that foreign exchange rates react very
reaping excess returns, while technical quickly and efficiently to news of changes
analysis holds that current and past price in U.S. employment figures, for example.
movements contain just the information Because the efficient markets hypothesis
needed to allow profitable trading. is frequently misinterpreted, it is important
What does this version of the efficient to clarify what the idea does not mean. It
markets hypothesis imply for technical does not mean that asset prices are unrelated
analysis? Under the efficient markets to economic fundamentals.10 Asset prices
hypothesis, only current interest rates and may be based on fundamentals like the pur-
9
risk factors help predict exchange rate chasing power of the U.S. dollar or German
There are a number of versions changes, so past exchange rates are of no mark. Similarly, the hypothesis does not
of the efficient markets hypoth- help in forecasting excess foreign exchange mean that an asset price fluctuates randomly
esis. This version is close to
returns—i.e., if the hypothesis holds, tech- around its intrinsic (fundamental) value.
that put forward by Jensen
(1978).
nical analysis will not work. Malkiel’s If this were the case, a trader could make
summary of the attitude of many economists money by buying the asset when the price
10
For an example of an incorrect toward technical analysis in the stock was relatively low and selling it when it was
interpretation of the efficient market is based on similar reasoning: relatively high. Rather, “efficient markets”
markets hypothesis, see means that at any point in time, asset prices
Murphy (1986, p. 20-21) who
The past history of stock prices cannot represent the market’s best guess, based on
offers, “The theory is based on
the efficient markets hypothesis,
be used to predict the future in any all currently available information, as to the
which holds that prices fluctuate meaningful way. Technical strategies fundamental value of the asset. Future price
randomly about their intrinsic are usually amusing, often comforting, changes, adjusted for risk, will be close to
value. . . . it’s just unrealistic to but of no real value. (Malkiel, 1990, unpredictable.
believe that all price movement p. 154.) But if any pattern in prices is quickly
is random.” bid away, how does one explain the
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apparent trends seen in charts of asset published and taken to indicate that
prices like those in Figure 1? Believers in trading rule strategies can yield profits.
efficient markets point out that completely For example, there is a vast literature on
random price changes—like those generated pricing anomalies in the equity markets,
by flipping a coin—will produce price summarized by Ball (1995) and Fortune
series that seem to have trends (Malkiel, (1991), but Roll (1994) has found that
1990, or Paulos, 1995). Under efficient these aberrations are difficult to exploit in
markets, however, traders cannot exploit practice; he suggests that they may be par-
those trends to make money, since the tially the result of data mining.
trends occur by chance and are as likely to
reverse as to continue at any point. (For
example, some families have—purely by Trading Rules
chance—strings of either boys or girls, yet With these considerations, two kinds
a family that already has four girls and is of trading rules have been commonly
expecting a fifth child still has only a 50 tested: filter rules and moving average rules.
percent chance of having another girl.) As a preceding section of this article
explained, filter rules give a buy signal
when the exchange rate rises x percent
EVALUATING TECHNICAL over the previous recent minimum.
ANALYSIS The analyst must make two choices to
The efficient markets hypothesis construct a filter rule: First, how much
requires that past prices cannot be used does the exchange rate have to rise, or
to predict exchange rate changes. If the what is the size of the filter? Second, how
hypothesis is true, technical analysis far back should the rule go in finding a
should not enable a trader to earn profits recent minimum? The filter rules studied
without accepting unusual risk. This sec- here will use filters from 0.5 percent to 3
tion examines how two common types of percent and go back five business days to
trading rules are formulated and how the find the extrema.12 A moving average rule
returns generated by these rules are gives a buy signal when a short moving
measured. Problems inherent in testing average is greater than the long moving
the rules, measuring risk, and drawing average; otherwise it gives a sell signal.
conclusions about the degree of market This rule requires the researcher to choose
efficiency are discussed.11 the lengths of the moving averages. The
moving average rules to be tested will use
short moving averages of 1 day and 5 days
Finding a Trading Rule and long moving averages of 10 days and
A basic problem in evaluating 50 days. Both the filter rules and the
technical trading strategies is that rules moving average rules are extrapolative, in
requiring judgement and skill are impossible that they indicate that the trader should
to quantify and therefore unsuitable for buy when the exchange rate has been 11
A number of previous studies
testing. A fair test requires fixed, objective, rising and sell when it has been falling. have documented evidence of
commonly used trading rules to evaluate. profitable technical trading rules
An “objective” rule does not rely on indi- in the foreign exchange market:
vidual skill or judgement to determine buy Profits
Sweeney (1986); Levich and
or sell decisions. The rule should be com- The trading rules switch between long Thomas (1993); Neely, Weller,
monly used to reduce the problem of and short positions in the foreign currency. and Dittmar (1997).
drawing false conclusions from “data Recall that a long position is a purchase 12
As with most aspects of techni-
mining”— a practice in which many of foreign currency—a bet that it will go cal analysis, the choice of filter
different rules are tested until, purely by up—while a short position is the reverse, size and window lengths has
chance, some are found to be profitable selling borrowed foreign currency now in been determined by practition-
on the data set. Negative test results are the hope that its value will fall. Denoting ers through a process of trial
ignored, while positive results are the percentage change in the exchange rate and error.
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Table 1
NOTES: The first two columns of the top panel characterize the length of the short and long moving averages used in the moving-average
trading rule. The third column is the annualized asset return to the rule, while the fourth column is the monthly standard deviation of
the return. The fifth column is the number of trades over the 23-year sample. The sixth column is the Sharpe ratio, and the last two
columns provide the CAPM beta with the S&P 500 and the standard error of that estimate. The lower panel has a similar structure,
except that the first column characterizes the size of the filter used in the rule. All extrema for filter rules were measured over the
previous five business days.
($ per unit of foreign currency) from date t average of daily U.S. dollar bid and ask
to t+1 by DSt, and the domestic (foreign) quotes for the DM, yen, pound sterling, and
overnight interest rate by it$ (itDM), then the Swiss franc.14 All exchange rate data begin
overnight return from a long position is on 3/1/74 and end on 4/10/97. These four
approximately given by Equation 1: series are called $/DM, $/¥, $/£, and $/SF.
Because the results for the four exchange
13
The estimate of transactions (1) RtDM ; itDM + DSt – it$. rates were similar, full results from only
costs used here is consistent the $/DM will be reported in the tables.
with recent figures. Levich and The return to a short position is the nega- Table 1 shows the annualized
Thomas (1993) consider a tive of the return to a long position. The percentage return, monthly standard
round-trip cost of 0.05 percent return to a trading rule over a period of deviation (a measure of the volatility of
realistic, as do Osler and Chang
time is approximately the sum of daily returns), number of trades per year, and
(1995).
returns, minus transactions costs for each two measures of risk, the Sharpe ratio and
14
The exchange rate data were trade. Transactions costs are set at 5 basis the CAPM beta, for each of the 10 trading
obtained from DRI and were points (0.05 percent) for each round trip in strategies for the $/DM. The Sharpe ratio
collected at 4:00 p.m. local the currency. A round trip is a move from and CAPM betas are discussed in some
time in London from Natwest a long position to a short position and detail in the shaded insert. The mean
Markets and S&P Comstock.
back or vice-versa.13 annual return to the 10 rules was 4.4 per-
Daily overnight interest rates
are collected by BIS at 9:00
cent, and 38 of the 40 trading rules were
a.m. London time. Interest profitable (had positive excess return) over
Evidence from Ten Simple Technical the whole sample. These results cast doubt
rates for Japan were unavail-
able before 3/1/82, so the Trading Rules on the efficient markets hypothesis, which
interest rates before this date Six filter rules and four moving average holds that no trading strategy should be
were set to 0 for the $/¥ case. rules were tested on data consisting of the able to consistently earn positive excess
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that an investor could have lost by using the the degree of inefficiency. Risk is notoriously
moving average trading rule was –28.2 per- difficult to measure. In fact, a major area
cent; this loss, which would have occurred of study for macro and financial economists
between March 7, 1995, and August 2, 1995 for the last 10 years has been to explain
(a period of 149 days), translates into an why the return on stocks is so much higher
annual rate of – 69.2 percent. In other than that on bonds, a phenomenon called
words, an investor using this rule would the equity premium puzzle. Of course, at
have lost almost 30 percent of his capital least part of the answer is that stocks are
over this five-month period. Similarly, the much riskier than bonds, but there is no
maximum loss for this technical trading generally accepted model of risk that will
rule in a complete calendar year was – 9.8 explain the size of the return difference.16
percent in 1995, but – 17.8 percent for the Defenders of the efficient markets hypoth-
S&P 500 in 1981.15 esis maintain that the discovery of an
Perhaps the biggest obstacle to apparently successful trading strategy may
exploiting technical rules is that while the not indicate market inefficiency but, rather,
returns to stocks depend ultimately on the that risk is not measured properly.
profitability of the firms in which the stock Another problem is that of “data
is held, the source of returns to technical mining”: If enough rules are tested, some—
analysis is not well understood; therefore, purely by chance—will produce excess
the investor does not know if the returns returns on the data. These rules may not
will persist into the future or even if they have been obvious to traders at the begin-
continue to exist at the present. Indeed, ning of the sample. In fact, the rules tested
Figure 5 shows that the post-1992 return here are certainly subject to a data-mining
to the (1,10) moving average rule for the bias, since many of them had been shown
$/DM has been negative. to be profitable on these exchange rates
over at least some of the subsample. Closely
related to the data-mining problem is the
Do These Results Measure the tendency to publish research that overturns
Degree of Market Efficiency? the conventional wisdom on efficient
There are a number of problems asso- markets, rather than research that shows
ciated with inferring the degree of market technical analysis to be ineffective. One
efficiency from the apparent profitability of solution to the data-mining problem is
these trading rules. The first problem is suggested by Neely, Weller, and Dittmar
the data. To test the profitability of a (1997), who apply genetic programming
trading rule, the researcher needs actual techniques to the foreign-exchange market.
prices and interest rates from a series of Genetic programming is a method by which
simultaneous market transactions. Unfor- a computer searches through the space of
tunately, simultaneous quotes for daily possible technical trading rules to find a
exchange rates and interest rates are not group of good rules (i.e., rules that generate
generally available for a long time span. positive excess return). These good rules
For example, these exchange-rate data are then tested on out-of-sample data to
were collected late in the afternoon, while see if they continue to generate positive
the interest rates were collected in the excess returns.
morning. Although most economists
judge this problem to be very minor, some
15
The returns for complete calen- argue that the trading rule decisions could RETHINKING THE EFFICIENT
dar years were available from not have been executed at the exchange MARKETS HYPOTHESIS
1975 through 1995. rates and interest rates used. Early research in finance on the
16
Kocherlakota (1996) and The second problem is that without a efficient markets hypothesis was very
Siegel and Thaler (1997) dis- good model of how to price risk, positive supportive; little evidence was found of
cuss the equity premium puzzle excess returns resulting from the use of profitable trading rules after transactions
extensively. trading rules cannot be used to measure costs were accounted for (Fama, 1970).
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the informed participants will reveal months. That is, if the exchange rate has
some of their private information to the risen recently, market participants expect it
uninformed agents. For example, if the to continue to rise in the near future
informed agents know of fundamental (Frankel and Froot, 1987). Also, the suc-
forces that are likely to make the exchange cess of extrapolative traders tends to feed
rate rise in the future, they are likely to buy on itself. Frankel and Froot (1990) argue
the foreign currency and thereby bid up the that extrapolative traders’ success during
publicly observed bid and ask prices. The the early part of the large dollar apprecia-
uninformed agents might infer from the rise tion of 1981-1985 convinced many other
that the rate will continue to rise and, as traders to follow extrapolative rules,
a result, they might buy more foreign driving the dollar up even further.
exchange, pushing the rate up themselves
in a self-fulfilling prophecy.20 This inference
from past price behavior is extrapolative tech- Central Bank Intervention
nical analysis: It assumes that the exchange The other popular explanation for the
rate will continue moving as it has in the apparent profitability of technical trading
recent past. The uninformed traders may rules is that technical traders are able to
continue to buy foreign exchange past the profit consistently from central bank inter- 20
Treynor and Ferguson (1985),
point where it is supported by fundamentals. vention. Some central banks frequently Brown and Jennings (1989),
Although this story is most plausible for very intervene (buy and sell currency) in the Banerjee (1992), and Kirman
high-frequency (intraday) trading, it might foreign exchange market to move the (1993) construct models of
also generate longer-term swings in the exchange rate to help influence other vari- behavior in which information
exchange rate. ables like employment or inflation.22 is inferred from the actions of
There are other explanations for Because these actions are designed to con- others. One easily understood
extrapolative trading that jettison the trol macroeconomic variables rather than example is the problem of con-
assumption of rational behavior in favor of to make money, central banks may be sumers who must choose
the study of how people really make deci- willing to take a loss on their trading. between two restaurants. One
seemingly sensible strategy for
sions. This field, called behavioral finance, Trading rule profits may represent a
choosing would be to go to the
has concentrated on examples of seeming transfer from central banks to technical more crowded restaurant on
irrationality in decision making. Two find- traders. Lebaron (1996) found that most the theory that it is likely to be
ings of this field are that (1) experimental trading rule profits were generated on the crowded because it has better
participants seem unusually optimistic day before a U.S. intervention. Neely and food. This phenomenon
about their chances for success in games Weller (1997) find that “intelligent” depends on asymmetric
and (2) the behavior and opinions of trading rules tend to trade against the Fed; information.
members of a group tend to reinforce that is, they tend to buy dollars when they 21
Shiller (1988) and Shleifer and
common ideas or beliefs.21 For example, find out the Fed is selling dollars. This Summers (1990) discuss
members of a jury may become more con- tantalizing story does not fit all the facts, behavioral finance in more
fident about their individual verdicts if the however. For example, Leahy (1995) finds detail. Ohanian (1996) consid-
other members of the group agree. that U.S. foreign exchange operations ers the reasons for the collapse
Either explanation for extrapolative make positive profits, on average.23 This of bubbles.
trading implies that bubbles may be produced finding is inconsistent with the idea that 22
In the United States, the
by slow dissemination of private information central banks are giving money away to Federal Reserve and the U.S.
into the market, coupled with extrapolative technical traders. Treasury generally collaborate
trading rules. There is some evidence to on foreign exchange interven-
support this explanation. Eichenbaum and tion decisions, and operations
Evans (1995) found that foreign exchange Why Are the Profits Not are conducted by the Federal
markets reacted gradually to money supply Arbitraged Away? Reserve Bank of New York on
shocks, over a period of many months, Whether the trends or inefficiencies in behalf of both.
instead of instantly incorporating the new exchange rates are created by swings in 23
See Szakmary and Mathur
information. Surveys revealed that foreign expectations or by central bank intervention, (1996) for more on central
exchange market participants’ expectations efficient market advocates would ask why bank intervention and trading
are extrapolative at horizons up to six any predictable returns in exchange rates rule profits.
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The simplest widely used measure of risk is the Sharpe ratio or the ratio of the
average annual excess return to a measure of excess return volatility called the stan-
dard deviation. Higher Sharpe ratios are desirable because they indicate either higher
average excess returns or less volatility. A commonly used benchmark of a good
Sharpe ratio is that of the S&P 500, which Osler and Chang (1995) estimated to be
about 0.32 from March 1973 to March 1994.
A major drawback to Sharpe ratios is that they ignore an important idea in
finance: An investment is risky only to the extent that its return is correlated with
the return to a broad measure of the investments available. To see this, consider the
risk associated with holding a portfolio of assets whose returns are each individually
volatile but completely independent of each other. Each year, the assets in the portfo-
lio that do unusually well will tend to offset those that do unusually poorly. The
portfolio as a whole will be much less risky than any of the individual assets. The
more assets in the portfolio, the less risky it will be. In fact, if enough of these inde-
pendent assets are grouped together into a portfolio, the return on this portfolio
becomes certain. This means that investors do not need to be compensated for hold-
ing risky assets that are not correlated with all the other assets they can buy (the mar-
ket portfolio), because the risk of each uncorrelated asset can be reduced to zero if
the portfolio contains a large enough variety of these assets. On the other hand,
assets for which returns are positively correlated with those of the other assets on
the market need a higher expected return to convince investors to hold them.
This idea motivates the second measure of riskiness, the CAPM beta: the coeffi-
cient from the linear regression of an asset’s (or trading rule’s) excess return on the
excess return of a proxy for the market portfolio, the return to a broad equity index
like the S&P 500. An estimated beta equal to zero means that the trading rule is
bearing no systematic risk, while significantly positive betas indicate that a trading
strategy is bearing some risk, and a beta equal to one means that the trading rule
moves closely with the market, so that following it requires the investor to accept
significant risk.
should not be arbitraged away. One answer know the equilibrium value of the exchange
to this question is that speculators have rate with any certainty, so they cannot dis-
short horizons and are deterred from spec- tinguish bubbles from movements in
ulating against the trends by the risk that fundamentals. Investors who bet on long-
such a strategy would incur. There are sev- run reversion to fundamental values in
eral reasons for this: First, traders typically exchange rates may be wiped out by short-
operate on margin, borrowing some of the run deviations away from those values.24
money with which they trade. With a lim- Explaining the success of technical
ited line of credit, the borrowing costs trading rules with bubbles begs one more
24
Both Shleifer and Summers would add up if traders were not able to question: Why do destabilizing extrapolative
(1990) and Shleifer and turn a quick profit. Second, a trader’s traders not lose their money? Friedman
Vishny (1997) discuss the performance is typically evaluated on (1953) showed that destabilizing specula-
importance of risk in speculat- relatively short horizons (less than a year). tion is doomed to lose money and so drive
ing against bubbles. Third, there may be institutional or legal the speculators out of the market. Friedman
25
Essentially the same argument restrictions that prevent some types of argued that speculation can only destabilize
is presented more simply in enterprises from taking on “excessive” asset prices if the speculators consistently
Shleifer and Summers (1990). exchange risk. And finally, traders do not buy when the asset price is above its equi-
F E D E R A L R E S E R V E B A N K O F S T. L O U I S
36
SEPTEMBER/OCTOBER 1997
librium value (driving the price up further) transactions data or experimental work
and sell when the asset price is below its on expectations formation may provide a
equilibrium value; as the destabilizing better understanding of market behavior.
speculators lose their money, he
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