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Foreign Exchange Markets

Alina F. Serban*

Department of Economics, West Virginia University

Morgantown WV, 26506

November 2009

Abstract

The literature on equity markets documents the existence of mean reversion and

momentum phenomena. Researchers in foreign exchange markets find that foreign

exchange rates also display behaviors akin to momentum and mean reversion. This paper

implements a trading strategy combining mean reversion and momentum in foreign

exchange markets. The strategy was originally designed for equity markets, but it also

generates abnormal returns when applied to uncovered interest parity deviations for ten

countries. I find that the pattern for the positions thus created in the foreign exchange

markets is qualitatively similar to that found in the equity markets. Quantitatively, this

strategy performs better in foreign exchange markets than in equity markets. Also, it

outperforms traditional foreign exchange trading strategies, such as carry trades and

moving average rules.

JEL classifications: F31, G11, G15

Keywords: Uncovered Interest Parity; Mean Reversion; Momentum; Foreign Exchange;

Trading Strategies.

*

Tel: +1 304 292 2460; fax: +1 304 293 5652; e-mail: alina.serban@mail.wvu.edu.

1. Introduction

Foreign exchange market trading strategies have attracted much attention, especially

since Fama (1984) introduced the “forward puzzle”, which argues that forward exchange

rates are biased predictors of spot exchange rates. This paper sets forth a new strategy in

the foreign exchange (FX) markets that combines mean reversion and momentum. Even

though the strategy was originally designed for equity markets, I find that it produces

higher Sharpe ratios than traditional FX strategies.

The starting point of this paper, the “forward puzzle”, results from the rejection of

the Uncovered Interest Parity (UIP) theory. UIP states that the change in the exchange

rate should incorporate any interest rate differentials between the two currencies. A large

literature exists examining if and when UIP holds.1 This paper tries to find a pattern in

the deviations from UIP and to explore the similarity between this pattern and that of

stock returns. The literature reveals what looks like mean reversion and momentum in

both markets. A long–run mean reverting pattern in currency values has been uncovered

by Engel and Hamilton (1990); a short–term momentum effect generates profitability in

FX market trading (Okunev and White, 2003).2 Chiang and Jiang (1995) notice that

foreign exchange returns show strong positive correlations in the short-run (momentum

behavior) and negative correlations in the long-run (mean reverting behavior). This paper

generates abnormal returns by employing a strategy that combines the long–run and

short–run patterns of the deviations from UIP.

1

For more details on UIP, see for instance Bilson (1981); Froot and Frankel (1989); Chabout and Wright

(2005).

2

Okunev and White actually use a moving average rule to create profits for the speculators on the FX

market, but they name this “a simple momentum strategy”. The strategy in my paper is different from

theirs.

1

The success of the combined momentum-mean reversion strategy brings about

another interesting issue: the puzzling relationship between stock and FX markets. The

similarities between the stock and FX markets are perplexing because macroeconomic

fundamentals explain stock returns, but not exchange rates (Meese and Rogoff, 1983 a,

b). Traditional theory dictates that two markets not relying on the same fundamental

variables cannot behave similarly. Yet, I find the two markets comparable. This result is

in line with early studies that depict similar empirical regularities in FX and stock

markets (Mussa, 1979). One possible explanation springs from Engel and West (2005),

who find that exchange rates explain macroeconomic fundamentals, not the reverse. This

finding, corroborated with the finding that fundamentals explain stock returns, provides

one possible channel for the relation between the two analyzed markets. Another

fascinating explanation is that the risk factors affecting both stock and FX returns remain

unknown but are somehow connected. An additional explanation is that similar

behavioral biases operate in both markets, leading to similar inefficiencies.

To explore the similarities between the stock and FX markets, I first consider the

non-parametric approach that Jegadeesh (1990) and Jegadeesh and Titman (1993, 2001)

exploit. These papers construct portfolio deciles based on previous months’ returns and

choose a winner and a loser decile. By buying the winner and selling the loser a zero-

investment portfolio is constructed and this portfolio is held for less than a year. The

authors find that the return on their zero-investment portfolio is always positive. If this

portfolio is held for more than a year, however, the return becomes zero or negative. In

Jegadeesh and Titman (2001), the authors exploit the rationale behind these results. They

reject data mining explanations and risk compensation, finding that behavioral models

2

Balvers and Wu (2006) use an alternative approach to generate trading profits in the stock market: a parametric strategy. However. The Sharpe ratios obtained in the FX market are significantly larger than those obtained in the stock market. hence we expect similar trading strategy returns for the zero investment portfolios. The final section concludes. They consider the effect of momentum and mean reversion jointly and conclude that the resulting strategy can lead to significant profits when applied to the stock markets of 18 developed countries. Consequently. The aforementioned non-parametric strategy is used in the FX market by identifying a winner and a loser currency based on previous deviations from UIP. A contrarian strategy or a momentum strategy by itself leads to lower abnormal returns than the combination strategy. The paper is organized as follows. I find that the parameters obtained for the FX market are quantitatively similar to those for the stock market. The third section describes the model and the fourth examines the model empirically and compares the results to the existing literature. in the subsequent 4–5 years. The second section describes the data and presents preliminary results showing that deviations from UIP exhibit momentum initially and subsequent mean reverting behavior. I consider the Sharpe ratios. the winner and loser portfolios switch positions. I find that the winner continues to have high returns and the loser low returns for the subsequent 9–12 months.partially explain the abnormal returns. but. The FX market returns have lower volatility than equity market returns. but in the two different markets. one cannot combine mean reversion and momentum strategies with this approach. which allow me to compare risk-to- reward profiles of the same strategy. 3 .

The US Dollar serves as the home currency. 4 . The sample period is December 1978 through February 2008. Swiss Franc. Canadian Dollar. the data come from two sources: for the period December 1978 – December 2001 from the BIS dataset. That is why most of the literature only considers data on the FX market starting around 1979.1. The risk free rate is the one-month Treasury bill rate (from Ibbotson Associates). Japanese Yen and Dutch Guilder. French Franc. 3 It took a few years after the collapse of the Bretton Woods System to establish a floating exchange system and for speculation to be possible. I work with December 1978 through February 2008 as the time period for the non-Euro zone countries and December 1978 through December 1998 for the Euro-zone countries.2. Data Description The data set consists of the 1 month forward and spot exchange rates from the Bank of International Settlements and Datastream. Due to data availability. the literature on the FX market usually only covers these currencies. in which currency speculation can be easily implemented. I focus on well developed currencies with liquid markets. Data Description and Preliminary Statistics 2. I obtain monthly data for the Belgian Franc. Due to availability.3 The German Mark is the only Euro-zone currency with data from December 1978 through February 2008 (after December 1998. German Mark/Euro. obtained from Kenneth French’s website. Italian Lira. and for January 2002 – February 2008 from Datastream. the Euro takes its place in the data). The monthly equity market returns are obtained from the Morgan Stanley Capital International (MSCI) Barra equity market price indexes for the same set of nine developed countries plus the US. UK Pound.

The “forward puzzle” suggests that the exact opposite happens: these currencies actually tend to depreciate. in units of home country currency per foreign country currency) . we obtain: rt − rti = sti+1 − sti . The UIP states that the markets equilibrate the return on the domestic currency asset with the expected yield of the uncovered position in the foreign currency.2.2. it follows that: sti+1 − sti = f ti − sti (5) 5 . investors leave their position uncovered from t to t+1 and only make arrangements to change the foreign currency into domestic currency at time t+1. Interest Parity Conditions UIP states that the currencies at a forward premium should appreciate. In other words: iE ( S ti+1 ) 1 + rt = (1 + rt ) (1) S ti With this strategy. If the investors leave nothing to chance and make arrangements to convert foreign to domestic at t+1 by using a forward exchange rate Ft. Taking logs of (1) and (2) and ignoring expectations. with f t i ≡ ln Ft i (4) If both conditions hold. absence of riskless arbitrage profits implies that: Ft i 1 + rt = (1 + rti ) (2) S ti Equation (2) is known as Covered Interest Parity (CIP). An investor who borrows money in their home country (with an interest rate of rt) and lends it in another country with a higher interest rate ( rti ) should expect a zero return due to the changes in exchange rate (denoted at time t by Sti . with sti ≡ ln S ti (3) rt − rti = f t i − s ti .

standard deviations and Sharpe ratios. 2008.97 percent. 6 . Burnside et al. Isard (2006).68 to 10. and Panel C shows descriptive statistics for a strategy of buying US index and short selling a foreign index. 1995). 2008). Panel B describes stock market excess returns computed from the MSCI Barra price indexes.4 This paper is concerned with the deviations from UIP. Byant (1995).82 to 1. the strategy that Panel C proposes gives very low mean returns (ranging from 4 The CIP is the condition used by large banks for determining the exchange rates and interest rates at which trading is actually conducted.76 to 23. The Sharpe ratios provide the proper comparison between the FX and equity markets since they remain invariant to the degree of leverage. leverage is widely used in practice to provide the desired mean returns. In Panel B. more dispersion exists in the data for the stock market returns than for the FX market. By taking the US stock market as the benchmark country (by analogy to the FX positions). [Insert Table 1 here] Panel A displays summary statistics for UIP positions in the FX market.08 to 13. denoted by yti and defined as follows: yti+1 = ( sti+1 − sti ) − ( f ti − sti ) = sti+1 − f ti (6) Table 1 presents summary descriptive statistics of the returns for UIP positions in the nine currencies and for various similar positions in the stock market: annualized mean returns. Evidently. as expected from the literature (Burnside.35 percent. the stock market counterpart of the UIP positions in the FX market..67 percent and standard deviations from 14.81 percent and the standard deviations from 4. 1989. The mean returns for the UIP positions in panel A range from -1. See Taylor (1987. the mean returns for the stock market indexes range from 7.Equation (5) accounts for the interest rate differential implied by the CIP condition. Given the low mean returns in the FX market (relative to the stock market).

The strategy considers the cumulative deviations from UIP for every currency over the previous J months (where J takes the values of 6. 1985. 24. 12. Koijen et al. I am the first to implement a strategy of combining mean 7 .31 to 4. The Sharpe ratios are relatively low in Panels A and C and relatively high in Panel B. Each month I rank the currencies on the basis of past deviations from UIP and the currency with the highest cumulative return classifies as the “winner”. The loser’s return appears to be a mirror image of the winner’s return. Balvers et al. Starting around year four. 9.. and very high standard deviations (from 13. consequently. Figure 1 summarizes the results for all permutations of this strategy. These results do not differ from the results on the stock market (De Bondt and Thaler.52 to 23. or 12). 2001) strategy easily and effectively by applying this strategy to the deviations from UIP. 2. 1987. the results are reversed and the losers outperform the winners. 9.” For these currencies I compute the cumulative deviations from UIP over the subsequent K months (where K is 6. while the currency with the lowest return becomes the “loser. and 60). 2006). Lee and Swaminathan.29 percent). the holding periods overlap. Confirming Mean Reversion and Momentum To check for mean reversion and momentum. 2001. 1993.31 percent). this again shows a much higher dispersion in the equity market than in the FX market.3. Jegadeesh and Titman. I assign the winner and loser for every month.-2.. one can ascertain effortlessly that the winner’s mean return starts out positive and continues to be positive until the momentum effect disappears (after about one year). 36. [Insert Figure 1 here] From the graph. 48. one can use the Jegadeesh and Titman (1993. 2000. 2000.

1. The stationary component classifies as a first-order autoregressive process that represents the long temporary swings in stock prices (characterized by coefficient δ). while the ρ ij represent the momentum strength and can vary by country and by lag. the return of my strategy is: J y ti = −(1 − δ i )( xti−1 − µ i ) + ∑ ρ ij ( xti− j − xti− j −1 ) + ε ti (9) j =1 8 . Model and Parameter Estimation 3. but adding a coefficient for the momentum effect ρ. Model Fama and French (1988) and Summers (1986) consider a simple model for stock prices (their natural log is represented by x) that is the sum of a random walk and a stationary component. The parameter µ captures the random walk drift component.reversion and momentum in the FX market. Balvers and Wu (2006) construct the log of stock prices (with dividends added and reinvested) as: J xti = (1 − δ i ) µ i + δ i xti−1 + ∑ ρ ij ( xti− j − xti− j −1 ) + ε ti (7) j =1 They note that the log of the price with dividends reinvested implies that the return is yti = xti − xti−1 and that the log of the price equals the cumulative return after correction for market risk: t xti = ∑ y si (8) s =1 I use equation (7) to find abnormal returns in the FX market. The δ i represent the speed of mean reversion and can differ by country. 3. Similarly. This strategy generates significant abnormal returns in this market. The parameter µi also varies by country. From equation (7). as shown in the following sections.

I consider the simple model in which ρ ij only varies by country (as does δ i ): yti = −(1 − δ i )( xti−1 − µ i ) + ρ i ( xti−1 − xti− J −1 ) + ε ti (11) Taking into consideration the definitions of MOM and MRV. Intuitively. a positive momentum effect pushes the return upward. then the mean reversion and momentum effects should be correlated. check Balvers and Wu. 2006. Therefore. but empirically I expect them to fall inside the interval. In equation (9) it is theoretically possible for ρ ij and δ i to be outside the interval [0. one can anticipate a negative correlation between the two effects. equation (9) and stationarity imply: cov(MRVt i . xti− J )] var( xti ) < 0 5 Since δ i and ρ i both lie between 0 and 1. Omitting mean reversion requires δ i = 1 in equation (11): yti = α MOM i i + β MOM ( xti−1 − xti− J −1 ) + ε ti. hence all the ρ ij in their models equal zero. the covariance between the two effects has a negative sign. The models proposed by Fama and French (1988) and Summers (1986) consider only mean reversion. one can write my model as: yti = MRVt i + MOM ti + ε ti (10) If the ρ ij and 1– δ i diverge from zero. In order to check for that correlation. MOM ti ) = −(1 − δ i ) ρ i [1 − corr ( xti . The first part of equation (9) represents the mean reversion component. while the second part represents the momentum effect. Therefore. 1]. while the mean reversion effect tends to bring the cumulative return back to its mean. Omitting one of the two effects leads to biased estimation of the parameters. 9 . so downward.MOM 5 For a complete derivation.

X ti−1 − X ti− J −1 ) Var ( X ti−1 ) > −(1 − δ i ) . Consequently. X ti−1 − X ti− J −1 ) Var ( X ti−1 ) < ρi . MOM i i Var ( X t −1 − X t − J −1 ) Hence. for all i and j ρ ij = ρ I use the full range of my sample and obtain the parameter estimates using a pooled model and J=12.MRV i Then: plim β MRV = −(1 − δ i ) + ρ i [1 − Corr ( X i t −1 ] . plim β i =ρ i i − (1 − δ ) [1 − Corr ( X i t −1 ] . By the same logic. Table 2 presents the results.2. µ.5)/ln(1.δ ). [Insert Table 2 here] 6 Half-life is the expected time for the analyzed stochastic variable to return half of the way toward the equilibrium level. It is computed as ln(0. I only allow µ i to differ by country (which accounts for possible “mispricing” at the beginning of the period). while: δi =δ . the measured impact of momentum is smaller if mean reversion is omitted. 10 . That is a very large number of parameters to estimate. i i Var ( X t −1 − X t − J −1 ) So the mean reversion coefficient estimation is inconsistent and implies a biased upward half-life.Consequently. 9 µ i and 9J ρ ij ). in order to avoid multicollinearity problems and to improve efficiency. Parameter Estimation The model in equation (9) considers a total number of parameters equal to 9(J+2) (9 δ i . ρ i = 0 in equation (11): yti = α MRV i i + β MRV xti−1 + ε ti. 6 3. leading to a possible spurious rejection of mean reversion. if one runs the following equation assuming no momentum.

The momentum parameter ρ pooled across countries is a statistically significant and positive 0.0076 .023 in the stock market).042 compared to 0. the strength of momentum is indeed smaller (still positive and statistically significant) and equal to 0. The mean reversion coefficient δ pooled across countries equals 0. The mean reversion coefficient increases in the pure mean reversion strategy (0. If we compare columns 1 and 2 of Table 2.0077).9843. The first column reports the parameter estimates when allowing both mean reversion and momentum. The theoretical asymptotic bias of the momentum coefficient ρ is cov( xt −1 . xt −1 − xt − J −1 ) − (1 − δ ) = −0. Intuitively.0078 and again it lies very close to the empirical bias var( xt −1 − xt − J −1 ) (–0. the half-life for the combination strategy diminishes. Both coefficients are statistically significant. this is expected due to two effects of momentum: the first 11 . These results lie very close to those obtained for the stock market by Balvers and Wu (2006): the half-life for the combination strategy remains the same for the two markets. the difference stays positive and very var( xt −1 ) close to the theoretical value (0.0416.0079). and the momentum effect is stronger in the FX market (ρ = 0. The theoretical asymptotic bias in the mean reversion coefficient when omitting momentum is cov( xt −1 . implying a half-life of 44 months.0157. In the pure momentum strategy.9921) leading to a very long half-life of 88 months.0337 (the momentum effect is stronger in the FX market than in the stock market even in this case). The speed of mean reversion 1 – δ is significantly positive and equals 0. xt −1 − xt − J −1 ) ρ = 0. Empirically. The second and third columns show the parameter estimates for each of the two pure strategies.

while the variance of mean reversion explains only about one-third as much of the variation in returns (1.30 in the FX market.12%. MOM ti ) + σ ε2 (12) The variance of the returns is determined in large part by the errors (hence the small R2 of 4. for the FX market. – 0.03 percent of the variation in the returns from UIP. 4. momentum and their covariance. From equation (10) we observe that: var( yti ) = var(MRVt i ) + var(MOM ti ) + 2 cov(MRVt i . the two effects hold similar importance in explaining the returns.initial effect of momentum is positive and causes the downturn to come later and the second momentum effect starts after the downturn and shortens the half-life. currently developed only for the stock market. Trading Strategies I employ a mean reversion – momentum combination strategy. Mean reversion remains a very important component and should not be disregarded as follows for instance from the bias in the momentum coefficient when mean reversion is omitted. The remainder of Table 2 reports the variance decomposition.35 in the stock market). while ρ and δ stay fixed by country and lags: 7 Balvers and Wu (2006) obtain 2.06 percent) and the rest by the variance of mean reversion.55 percent). I use the following variation of equation (9) by only allowing µ to change by country. 12 . For the stock market. The small coefficient of determination is actually higher than that obtained for the stock market. The correlation between the two effects is theoretically and empirically negative and about the same size as that obtained for the stock market (–0.7 The variance of momentum explains 4.

updating the sample period by one month each time. then months 2 to 1/3 of the sample +1 month and so on.4 percent for K=1 to 4. but ρ is assumed to equal zero for the pure mean reversion strategy and δ is assumed to equal one for the pure momentum strategy. 4. due to a very large number of parameters to estimate. [Insert Table 3 here] 8 So I use as a first sorting period months 1 to 1/3 of the sample. J yti = −(1 − δ )( xti−1 i −µ )+ ∑ ρ(x j =1 i t− j − xti− j −1 ) + ε ti (13) Based on the first 1/3 of the sample.1. 13 . The mean return for the zero-investment portfolio ranges from around 0. The Pure Mean Reversion Strategy Table 3 reports averages and standard errors for the annualized returns of Max and Max – Min portfolios for different holding periods K. after December 1998. 3. rolling the sample forward. one takes the decisions in the exact same way and using the same equation (13). 6. Max and Min are selected from the remaining four non-Euro countries plus the Euro. and 12). using OLS. Again. I only allow µi to change by country. 9. Max denotes the currency with the highest expected return and Min denotes the currency with the lowest expected return. For the results of the pure momentum and pure mean reversion strategies. one can choose from nine currencies. Panel A presents the results for the pure mean reversion strategy. I apply the same procedure. I estimate the return yti for each currency. In each subsequent period.1 percent for K=12.8 For December 1979 through December 1998. The shaded areas report the means of the zero-investment portfolios. I form a portfolio by taking a long position on Max and a short position on Min (denoted by Max – Min) and I hold these positions for the next K months (where K can be 1.

4.2. However. 6 or 9 months. These returns are similar to the 5–7 percent per year obtained by Okunev and White (2003) for their simple momentum-like 14 . Neely (1998) notes that there is a long-run tendency of exchange rates to revert to purchasing power parity (PPP) values and this might be why central banks make excess profits when intervening in the FX market. Depending on the time period considered.3 percent. they obtain mean excess returns ranging from 3. The pure mean reversion strategy this paper constructs leads usually to lower average returns. This result confirms the theoretical finding that avoiding the mean reversion component might give a shorter momentum lag. The trend of the mean returns is very similar to that obtained for the stock market. the two strategies are different in that the former presents a contrarian strategy based on reversion to the PPP.8 to 4. The Pure Momentum Strategy Panel B presents the annualized mean returns and standard errors for Max and Max – Min portfolios for different combinations of K and J when δ=1. A similar mean reversion strategy has not been implemented in the FX markets. but the annualized average Max – Min portfolio is usually smaller for the FX market (as expected). I only present the case of J=12. Some of the average returns for the zero-investment portfolio are negative. The averages are larger when J is 3. A study prepared by Deutsche Bank (2007) notices that PPP is one of the best fundamentals that can forecast the exchange rates and constructs a contrarian strategy. Rogoff (1996) finds that the PPP does revert to a long-run mean and typically the literature reports a half-life of three to five years. then increases to a maximum of 6 percent for K=12. Since the trend is similar for different J. However. The Max – Min mean portfolio return starts from a statistically significant 3 percent for K=1.

Including the no-transaction costs rows of the table allows a more direct comparison between the stock and FX markets. [Insert Table 4 here] The no-transaction costs strategy for J=12 generates a mean return for the zero- investment portfolio of around 11 – 12 percent and similar mean returns for J<12. For the combination strategy. the mean returns are much lower. For J=15. I consider the maximum of a 0. the transaction costs this paper employs are only estimated. while I use a strategy originally designed for the stock market. 9 Following Cochrane (2005.000721 .3.2207 to infinity). 1999. 1979 they range from 0. For comparison.05 to 0. the mean returns here outperform the Okunev and White (2003) strategy. 4.strategy. The procedure proposed by Cochrane multiplies the standard deviation of the return. in some cases. ranging from 2. This result is fascinating considering the fact that they employ a strategy designed for the FX market. According to Szakmary and Mathur. the table also reports the results using the same strategy in the stock market for each combination (J. I obtain the theoretical return. I check how the mean returns compare to the theoretical returns. FX market transaction costs are not very large.2 percent for developed countries.1997.00406 ). obtained from the expected return of the standard normal variable over the interval 1. K). and then by the square root of R2 ( 0.2 percent transaction cost. using different µ i and the same δ and ρ (across countries and momentum lags). LeBaron. which is subtracted from the return each time a purchase or short sell of a new currency occurs. However. by the standardized expected return of the currency in the top 9th of the standard normal distribution (0. The table also shows the outcomes of the strategy after transaction costs. and Goodman. standard errors and Sharpe ratios for the combination strategy.9 Transaction costs do not significantly alter the results. I use the results from Table 2. I obtain an 15 . 0.9 to 6.1894. p.2 percent. Also. 447). not actual. The Combination Strategy Table 4 presents the annualized mean returns.

As discussed previously.7 percent and standard errors of 0.644. For all K’s. (2000). I obtain the annualized theoretical return of the Max – Min portfolio to be 22. standard errors for the FX combination strategy are 33 percent of the standard errors for the stock combination strategy. (2000) also expected annualized return for the top currency of 11. Lee and Swaminathan (2000) obtain for a momentum strategy (holding period of one year) in the stock market an annual mean return of 10. For a buy- and-hold strategy.008 for a momentum strategy in the FX market. according to Balvers et al. 10 These differences between the two markets are typical. There are 25 pairs (J. the Sharpe ratio is the best metric for comparing the two different markets. So the results that derive from using this combination strategy for the stock market are not unusual.447 and that for the US is 0. On average. The comparison between these results and the results obtained through the pure mean reversion strategy is not straightforward. Okunev and White (2003) report annualized mean returns of 5 – 6 percent and standard errors of 0.6 – 12.025. K) for each of the two strategies and for 23 of these the combination strategy generates higher mean returns.7% annualized return obtained in Table 4. since the latter strategy assumes J=0. for the combination J = 12 and K = 1. After following the same procedure for the bottom currency.58%.006 – 0. This theoretical return is larger than the 12. In only one case. One can study this comparison by computing an overall average for the combination strategy for each K and finding the difference between that average and the mean zero-investment portfolios in Table 4. the mean returns increase with the use of the combination strategy. the Sharpe ratio for the stock market is larger than that for the FX market. This gives Sharpe ratios around 2. For instance.5 times higher for the FX than for the stock market. Comparing the average returns between the combination strategy and the momentum strategy is much easier.018 – 0. 16 . In this light the returns obtained in this paper are not too high. the Sharpe ratio for the world market is 0. 10 Different strategies have been employed in the equity market literature. The comparison between the FX market and the stock market is one of the main objectives of this paper. while the mean returns for FX are around 81 percent of the mean return for stocks.29%. Balvers et al.

11 The results obtained by implementing the combination strategy usually outperform other strategies in the FX market.5 and 1.060. for 24 out of 25. In Table 4.96 for a dynamic trading rule strategy. the momentum effect has already passed. or the Sharpe ratios. These results confirm that taking transaction costs into consideration in the FX market does not substantially modify the abnormal returns obtained. perhaps the most common strategy is carry trade. Burnside et al. 2002). Other strategies implemented in the FX market are technical trading rules.866. so the mean 11 Neely (1998.230 respectively. When creating the strategy that combines mean reversion and momentum. K) combinations the stock market has higher Sharpe ratios than the Balvers et al. When J=15. LeBaron (1999) finds annualized Sharpe ratios ranging from 0. usually it produces Sharpe ratios 2 or 3 times larger than the DeBondt and Thaler (1985) strategy. Moreover.67 to 0.apply two mean reversion strategies in the stock market: their own strategy. Hence the combination strategy produces much higher Sharpe ratios than other strategies employed in the stock market. (2008) only decrease to 4.6 percent when transaction costs are included.80 percent and a Sharpe ratio of 1. The average Sharpe ratio is 1. 17 . while the Sharpe ratio falls to 0. In the FX market. for 18 out of 25 (J.425 and 0.08 respectively. Sapp (2004) and Saacke (2002) obtain similar returns when further investigating the trading rules’ profitability. and DeBondt and Thaler’s (1985) contrarian strategy.9 percent for no transaction costs and 8.44 percent. higher Sharpe ratios than the DeBondt and Thaler (1985) strategy. the mean returns in Burnside et al. When considering transaction costs. (2000) strategy and. (2008) obtain an average annual return of 4. the average of annualized mean returns obtained for J<15 is 11. The Sharpe ratios obtained are 0. I next compare the Sharpe ratios for the combination strategy in the FX market to Sharpe ratios for other strategies in the FX market.

and the sample post January 1999 consists of just five currencies after the birth of the Euro. The FX literature considers mean reverting behavior toward PPP values and momentum trading 12 Results of robustness checks (different time periods. the FX market results for the combination strategy outperform other strategies employed in the FX market. Conclusion This paper employs a trading strategy. The results are also strong in comparison to strategies developed specifically for FX markets. 18 . Similarly.12 5. The stock market Sharpe ratios are not unusual. but significantly higher when one uses the combination strategy instead of other strategies. previously applied only to the stock market that creates abnormal returns in the FX market. The portfolio I construct should be even more profitable if the currency choices are more numerous. while the momentum effect is stronger than in the stock market. parameters allowed to vary by country and/or lag) do not significantly change the results and are available upon request. By running a simple parametric test. In the FX market the half-life of mean reversion is very close to that obtained for the stock market. Transaction costs do not alter the results significantly. but by applying one originally designed for the stock market. This paper contributes to the literature not only by applying a new strategy in the FX market.returns and Sharpe ratios of the strategy are noticeably lower (and in some cases negative when transaction costs are included). and also provide significantly higher Sharpe ratios than those found for the stock market. The combination strategy creates significant abnormal mean returns (slightly underperforming those of the stock market) and Sharpe ratios usually much higher than in the stock market. I consider developed countries only. I find that UIP deviations follow mean reversion and momentum.

and LeBaron. 1987) for the stock market: individuals tend to “overreact” to recent information. The striking results here. or whether. This paper challenges that finding. 1999). creating momentum. raise the question of why the two markets behave so similarly. Szakmary and Mathur. For instance. are due to these interventions that have no relevance for the stock market. A possible theory is the overreaction hypothesis proposed from a behavioral perspective (e. Many papers challenge the efficiency of the two markets.strategies based on moving average rules. instead of macroeconomic fundamentals. 1997. Up to now strategies employed in one market have not been successfully implemented in the other market. I find evidence that the FX and stock market inefficiencies have similar patterns. 1985. Neely (2002) examines the possibility that the FX market is inefficient due to Central Bank intervention. He argues that the abnormal returns obtained in the FX market through technical rules. but not existing in the stock market. I bring a fresh perspective to understanding FX market dynamics by considering risky asset returns. but profitable in the FX market (Sweeney. extreme movements in prices 19 . there exists an unobserved risk factor that explains these returns. likely due to fundamental differences between the two markets. This allows for the creation of a strategy based on returns (computed in this case from deviations from UIP) and a direct comparison of the exploitability of the return patterns between the FX and the stock market. technical trading rules were found to be completely useless in the stock market since the publication of Fama and Blume (1966).g. suggesting major differences between the markets. One is left to wonder whether the two markets are indeed inefficient. DeBondt and Thaler. in fact. 1986. After some time. on the other hand.

Examining this correspondence presents a promising direction for future research.will be followed by a return to fundamentals. but then revert to a long-run equilibrium. 20 . In foreign exchange markets. The correspondence between overreaction in the stock market and overshooting in the foreign exchange market may be responsible for the similarity in results in these two markets when the combined momentum and mean reversion strategy is applied. leading to movements in the opposite direction. Dornbusch (1976) shows that exchange rates tend to “overshoot” in their response to monetary policies. creating mean reversion.

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In: Frenkel J. Do Momentum-Based Strategies Still Work in Foreign Currency Markets?. Federal Reserve Bank of St. –––––––. 67-112. NBER. Elsevier 11. B. 1999. Rogoff. 1998.. Journal of Economic Literature 34. Technical Analysis and the Profitability of U. Swaminathan. Okunev. 2006. 1983b. Journal of International Economics 58. Sbuelz.. Journal of Financial and Quantitative Analysis 38. A. 1979. Momentum and Mean Reversion in Strategic Asset Allocation. 647-668. Neely. 23 . 3-24. Exchange Rates and International Macroeconomics. pp. C. 1983a. Price Momentum and Trading Volume.. Rodriguez. R. –––––––––––––. Carnegie-Rochester Conference Series on Public Policy.. Journal of International Economics 49. M. K. 1996. B.. LeBaron. Rogoff. 425-447.C. 211–232. Foreign Exchange Intervention. 2002. 3-17. EFA 2006 Zurich Meetings.. D. The Purchasing Power Parity Puzzle. R. 9-57.. Working Paper. Technical Trading Rule Profitability and Foreign Exchange Intervention.. The Temporal Pattern of Trading Rule Returns and Central Bank Intervention: Intervention Does Not Generate Technical Trading Rule Profits.. Journal of International Economics 14. 125-214. 2017-2069. 2000.S. Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?. White. 2003. C. J. (Ed). K. J. The Journal of Finance 55.. Mussa... Meese.. Empirical Regularities in the Behavior of Exchange Rates and Theories of the Foreign Exchange Market. Lee. Louis Review 80. The Out of Sample Failure of Empirical Exchange Rate Models.Koijen.

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163 Germany 1979:01-2008:02 -0. The deviations from UIP for the Belgian Franc. UK Pound. Table 1 Summary Statistics This table reports summary statistics (annualized mean.82 0.67 18.31 13.75 -0.770 Canada 1979:01-2008:02 11.56 0. Canadian Dollar.25 0.3666%).14 0.168 Belgium 1979:01-1998:12 -1. Stock Market (buy and hold excess returns) US 1979:01-2008:02 11.08 22.66 10.52 0. Panel B reports statistics for the excess returns.652 UK 1979:01-2008:02 12.36 23.585 Switzerland 1979:01-2008:02 11.32 0. obtained by subtracting the one-month US Treasury (taken from Kenneth French’s website).292 Switzerland 1979:01-2008:02 -1.175 UK 1979:01-2008:02 1. For the Sharpe ratios in Panels A and C.3666 should be read as 1.489 Netherlands 1979:01-2008:02 13.49 17.471 France 1979:01-2008:02 11.28 21. The mean and standard deviations are multiplied by 100 (so 1.015 Netherlands 1979:01-1998:12 -2.70 -0. Stock Market (returns of holding the US and shorting the specific country ) Canada 1979:01-2008:02 -0.192 Germany 1979:01-2008:02 1.44 17. standard deviation and Sharpe ratio) for deviations from UIP (Panel A).19 -0.085 25 .09 18. Sample Period Mean Standard Deviation Sharpe Ratio Panel A.49 9.63 9.51 -0.08 13.76 -0.20 0.55 0. FX Market Canada 1979:01-2008:02 1. Italian Lira. German Mark/Euro.008 Panel B. The stock returns are computed for the same nine countries plus the US from the MSCI Barra indices.69 -0.37 14.29 22.321 Germany 1979:01-2008:02 10.45 19.76 0.020 Italy 1979:01-1998:12 -0.73 21.42 -0.006 Switzerland 1979:01-2008:02 -0.03 0. stock excess returns (Panel B) and stock returns for a strategy of buying US stock and short selling foreign country stock (Panel C).24 9.91 -0.51 -0.662 Japan 1979:01-2008:02 7.06 0. Japanese Yen and Dutch Guilder relative to the US Dollar are computed as: yti = sti +1 − f ti .48 -0.551 Italy 1979:01-2008:02 11.73 23.08 9.200 Japan 1979:01-2008:02 -1.052 France 1979:01-1998:12 0.025 Italy 1979:01-1998:12 1. French Franc.85 19.63 14.669 Panel C.00 18.132 Belgium 1979:01-1998:12 -0.005 UK 1979:01-2008:02 -0.35 -0.059 France 1979:01-1998:12 -0.31 -0.28 9.177 Netherlands 1979:01-1998:12 -1. The sample period is reported in the table.758 Belgium 1979:01-2008:02 12. The data are taken from Bank of International Settlements and Datastream.58 0.36 17. so there is no need to subtract the average risk free rate.97 0.68 0.043 Japan 1979:01-2008:02 4.03 0.81 9.37 4.82 10. US is considered the benchmark country. Swiss Franc.28 0.07 15.

9E-05 Corr(MRVt.21E-04 σε2 6.55 0. The second column considers ρ=0. Moment MRV & MOM MRV only MOM only δ 0. while the third column assumes δ=1.35 Var(MRVt)/Var(yt) (%) 1.MOMt) -0.3049 0 - σε2/Var(yt) (%) 95. Table 2 Model Parameters and Variance Decomposition J This table reports the results of the following regression: yti = −(1 − δ )( xti −1 − µ i ) + ρ ( xti − j − xti− j −1 ) + ε ti .03 0 2. The data are pooled across currencies.92E-04 7.0026) 0.94 99.60 97. The standard errors are presented in brackets.1E-05 2.02E-04 7.0040) Var(yt) 7.05E-04 7.65 26 .9843 (0.8E-06 - Var(MOMt) 2. I use the full ∑j =1 sample 1979:01 – 2008:02 for the non-Euro currencies and for the German Mark and 1979:01 – 1998:12 for the Euro currencies (excluding the German Mark).0042) 0 0.9921 (0.02E-04 Var(MRVt) 1.0024) - ρ 0.65 R2 (%) 4.40 - Var(MOMt)/Var(yt) (%) 4. The first column presents the results for the above regression.9E-05 0 1.21E-04 7.0416 (0.0337 (0.40 2.06 0.

011 0.004 J=12 Max-Min 0.077 0. The portfolio Max – Min is held for K months.004 0.074 0.003 0.004 0.035 0.004 0.024 0.006 0. The currency with the highest expected return is denoted Max and that with the lowest expected return is denoted Min.033 0.021 0.004 J=3 Max-Min -0.006 0. The table presents annualized average returns (Ave) and standard errors (St error) for the Max and Max – Min portfolios.004 0.074 0.006 0. Based on the first 1/3 of the sample.053 0.004 0.022 0.188 0.033 0.006 0.056 0.004 J=9 Max-Min 0.007 0. δ=1 (the pure momentum strategy).006 0. The same procedure is applied in each subsequent period.047 0.004 J=15 Max-Min -0.066 0.004 0.036 0.003 0.015 0.008 Max-Min 0.043 0.007 0.003 0.004 0.023 0.006 0.033 0.031 0. For Panel A. Table 3 Performance of the Pure Mean Reversion Strategy and the Pure Momentum Strategy J This table uses the following regression: yti = −(1 − δ )( xti −1 − µ i ) + ρ ( xti− j − xti− j −1 ) + ε ti . I use the full sample 1979:01 – 2008:02 for the non-Euro currencies ∑ j =1 and for the German Mark and 1979:01 – 1998:12 for the Euro currencies (excluding the German Mark).061 0.006 Panel B.048 0. The averages for the Max-Min portfolios are provided in the shaded areas.004 0.042 0.002 Max 0.003 0.004 0. The Pure Mean Reversion Strategy K=1 K=3 K=6 K=9 K=12 Ave St error Ave St error Ave St error Ave St error Ave St error Max 0.005 0. each time updating the sample period by one month. The Pure Momentum Strategy K=1 K=3 K=6 K=9 K=12 Ave St error Ave St error Ave St error Ave St error Ave St error Max 0.002 Max 0.042 0.005 0.082 0.057 0.006 0.002 0.071 0.004 0.007 0.026 0.003 0.030 0.002 0. Panel A.004 0. I estimate the return y ti for each currency.004 0.122 0.028 0.007 0.036 0.029 0.006 0.002 0.056 0.036 0.003 0.004 0. For Panel B.002 27 .007 0.004 0.003 0.041 0.004 0.029 0.005 0.112 0.002 Max 0.021 0.004 J=6 Max-Min 0.046 0.033 0.003 0.045 0.006 0.039 0.004 0.006 0.004 0.032 0.046 0.008 0.061 0.056 0.002 Max 0.061 0. ρ=0 (the pure mean reversion strategy).042 0. using OLS.035 0.059 0.002 0.101 0.080 0.019 0.006 0.006 0.007 0.006 0.004 0.

FX market with transaction costs.006 2.015 0.075 0.730 0.018 0.017 0.004 0.117 0.600 FX (no trans costs) 0.015 0.007 0.113 0.006 1.033 0.005 0.781 Stock 0.991 0.175 0. 2006).006 1.006 0.097 0.163 0.014 0.005 -0.098 0.633 0.084 0.189 0.005 1.019 0. and stock market (as obtained from Balvers and Wu.021 0.005 1.673 J=12 FX (trans costs) 0.014 0.642 0.950 0.095 0.030 0.080 0.503 0.018 0. updating the sample period by one month each time.736 0.127 0.370 0.006 1.046 0.004 0.006 1.200 0.017 0.243 0.164 0.018 0.061 0.006 1.006 1.065 0.013 -0.015 0.014 0.687 0.145 0.084 0. using OLS.029 0.116 0.040 -0.113 0.006 1.004 0.006 2.005 1.005 1.006 0.119 0.464 0.095 0.496 0.062 0.174 0.110 0.392 0.248 0.140 0.464 0.256 0.004 1.378 J=15 FX (trans costs) 0.533 0.014 0. The same procedure is applied in each subsequent period.194 0.018 0.191 0.276 0.119 0.005 1.598 FX (no trans costs) 0.740 0.967 0.133 0. For each combination (J.042 Stock 0.162 0.127 0.068 0.017 0.161 0. The portfolio Max-Min is held for K months.004 1.145 0.500 Stock 0.251 0.125 0.633 0.196 0.108 0.086 0.031 0.005 1.005 1.064 0.005 1.064 0.087 0.037 0.004 0.050 0.017 0.005 1.006 1.379 28 .017 0.003 0.513 FX (no trans costs) 0.298 0.001 0.170 0.433 0.492 Stock 0.005 1. Based on the first 1/3 of the sample.327 0.087 0.486 0.070 0.079 0.564 0.038 J=3 FX (trans costs) 0.019 0. The currency with the highest expected return is classified as the Max.031 0.195 0.579 0.174 0.006 1.427 0. I report annualized average returns (Ave).402 FX (no trans costs) 0.004 1.095 0.642 0.692 0.007 2. and the one with the lowest expected return is the Min.004 0.005 1.017 0.003 0.733 0.340 0. standard errors (St error) and annualized Sharpe ratios (Sharpe) of Max-Min portfolios for: FX market without transaction costs.006 0.035 0.005 1.098 0.690 0.354 0.082 0.511 0.082 0.005 0.029 0.189 0.622 0.114 0.016 0.466 0.018 0.128 0.015 0.014 J=6 FX (trans costs) 0.315 0.126 0.602 0.006 0.140 0.015 0.005 1.015 0.211 Stock 0.006 0. K). Table 4 Performance of the Combination Strategy J This table uses the following regression: yti = −(1 − δ )( xti −1 − µ i ) + ρ ( xti − j − xti − j −1 ) + ε ti .113 0.015 0.223 0.084 0. I estimate the return yti for each currency.095 0.014 0.062 0.006 0.080 0.004 0.004 1.158 0.423 0.004 1.662 0.920 0.005 -0.098 0.262 J=9 FX (trans costs) 0.120 0.052 0. K=1 K=3 K=6 K=9 K=12 Ave St error Sharpe Ave St error Sharpe Ave St error Sharpe Ave St error Sharpe Ave St error Sharpe FX (no trans costs) 0.672 0.087 0.131 0.625 0.311 0.004 1.005 1.007 0.014 0. I use the full sample 1979:01 – 2008:02 for the non-Euro currencies ∑ j =1 and for German Mark and 1978:12 – 1998:12 for the Euro currencies (excluding German Mark).570 0.647 0.

005 Winner t u 0. Mean Returns for Winner and Loser (J=6) 0. 2001) strategy: over a period of J months.030 Period (months) Panel B.005 Winner e t 0.020 0.010 n -0.015 R e 0.010 -0.025 0.010 -0.005 Winner u 0.015 0.020 -0.015 R 0.015 s -0.010 t 0.015 -0.005 n s -0. Panel A.005 s -0.020 0.020 0.010 e 0. The mean returns of the winner and loser currencies are illustrated bellow for J=6 (Panel A).000 Loser u -0.020 Period (months) Panel C. Mean Returns for Winner and Loser (J=12) 0.005 0 6 9 12 24 36 48 60 r -0. I compute the deviations from UIP and find a loser and a winner currency.025 -0.010 R 0. Mean Returns for Winner and Loser (J=9) 0. These two currencies are held for K months. Figure 1 Average Annual Returns Figure 1 presents average annualized returns for the Jegadeesh and Titman (1993.015 -0.020 Period (months) 29 . J=9 (Panel B) and J=12 (Panel C).000 Loser r 0 6 9 12 24 36 48 60 -0.000 Loser r n 0 6 9 12 24 36 48 60 -0.

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