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Carry Trade Momentum Value: Trading Strategies For The Foreign Exchange Market

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A mixed securities portfolio can also be diversified using active currency strategies such as the carry trade. Various studies suggest this. However, there is a lack of corresponding products for private investors. By far the most popular trading concept on the foreign exchange market is the so-called carry trade. The carry is the current return on an investment, in the case of currencies it is the short-term interest rate that foreign exchange investors receive. Carry traders use interest rate differentials between different currency areas. They take out loans in currencies with low interest rates, such as the Japanese yen (JPY) or the Swiss franc (CHF). The money is reinvested in currencies with higher interest rates, such as the New Zealand Dollar (NZD). If the exchange rate remains unchanged, the investor collects the interest difference. At first glance, that sounds like a safe arbitrage business. But appearances are deceptive. A carry trade is high risk. It only works as long as the loan currency does not rise excessively or the investment currency does not fall. Because then the interest gains are quickly overshadowed by exchange rate losses.

CARRY TRADES: HIGH RETURNS, HIGH RISK

In the past, however, carry trades often worked. The currencies of countries that offer high interest rates tend to appreciate because investors like to invest where they expect attractive returns. On a long-term average, carry-trade strategies produced decent profits. Depending on the study period, the pool of tradable currencies and the amount of the transaction costs taken into account, annual returns of 5.7 to 8.5 percent are calculated with a volatility that was significantly below that of the international stock markets. At that time, the trading strategy brought high double-digit profits. The turnover of the carry traders swelled so much that they were even visible in the trading data of the global foreign exchange markets.

RISK OF FALLING DURING FINANCIAL MARKET CRISES

The seemingly paradisiacal market environment for carry trade investors collapsed in 2008 at the height of the global banking crisis. Depending on how the individual carry trade strategies were designed, they lost between 10 and 40 percent within two months. During the Asian crisis between 1997 and 1998, carry traders also suffered heavy losses, while stock markets continued to rise. 2011, when the international capital markets came under renewed pressure due to the Greek crisis, was also a difficult year.

However: During the Internet crisis between 2000 and 2003 when the stock exchanges worldwide collapsed and some leading indices lost more than 50 percent, carry trade strategies delivered high profits and contributed significantly to the diversification of a mixed portfolio.

THE MOMENTUM STRATEGY: THE WINNER IN THE WAKE

Another trading concept are so-called momentum strategies. These are trend-following systems that fund managers and investors implement in various asset classes such as stocks, commodities and corporate bonds . They are now standard strategies on the foreign exchange market too. They are based on the hope that currencies that have risen over a period of time will continue to rise. And that currencies that have fallen will keep falling. From a pool of currencies, those with the highest profits for long positions and those with the highest losses for short positions are selected. The long-term average returns of such strategies depend crucially on the holding period of the individual positions. The more frequently the portfolio is checked and currencies are exchanged that no longer meet the strategy criteria, the higher the performance. Strategies with a holding period of one month produce the best results. If the portfolio is only adjusted annually, the yields drop by around 70 percent in some cases.

TRANSACTION COSTS REDUCE THE RETURN

Another important influencing factor is the period of time used to determine the winning and losing currencies. Here, too, the short-term oriented concepts deliver the highest profits. If the individual positions are selected on the basis of the past performance of one or three months and the portfolio is also updated monthly, momentum strategies achieve an average annual return of 9.4 percent. With a 12-month performance as a selection criterion, the profit drops to a good 6 percent. With volatility well below that of stocks, that still seems lush. Unfortunately, another factor that plays an important role has not yet been taken into account: the transaction costs. With every currency purchase, the dealer, for example a bank, collects the difference between the on and the sales price (spread). It is obvious that the short-term oriented strategies cause the highest transaction costs. If you take the officially reported spreads as a basis, the returns of the best strategies drop to around 4 percent per year. How high the transaction costs actually are depends on the market power of a portfolio manager and his company, other studies have shown. The higher the sales (and capital under management), the lower the trading costs.

VALUE STRATEGIES: INVEST COUNTERCYCLICALLY IN CURRENCIES

The exact opposite of trend following systems are so-called value strategies. Value investors are not only on the stock markets, where they buy undervalued companies that little investors are currently interested in. Such countercyclical strategies can also be implemented in the foreign exchange markets. One of the most popular is based on the theory of purchasing power parities. After that, a basket of goods at home should cost the same as abroad. Let us assume that this shopping cart costs 1000 euros in Germany and 3000 zloty in Poland. At a nominal exchange rate of 4 zloty per euro, it would cost a German consumer only 750 euros. Under these conditions it would be effective to import goods from Poland. This increases the demand for the zloty – and with it the exchange rate. If the Polish goods prices do not pick up, the import (transaction costs excluded) is lucrative until the exchange rate has risen to 3 zloty per euro. Then a consumer at home receives just as much goods for his money as he does abroad – purchasing power parity is established.

So much for the theory was the first to be postulated by Spanish monks in the 16th century. The respective exchange rate, which ensures the equalization of purchasing power at home and abroad, is regarded in the foreign exchange markets as a kind of fair equilibrium exchange rate. If a currency is cheaper, it is considered undervalued – and vice versa. The most popular concept for determining the valuation of currencies, which is based on the purchasing power parity theory.

Hello, I have been working as an investment consultant and author for more than 20 years. I love what I do and I have enriched everyone around me. A lot of money is not important, the main thing is how you use the money.

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