Understanding the profitability of currency-trading strategies.

• Author: Burnside, Craig
• Position: Research Summaries

The profitability of simple currency-trading strategies presents perhaps even more of a challenge to traditional asset-pricing theory than does the equity-premium puzzle, which has received an enormous amount of attention. Understanding the properties of currency-trading strategies is important not just for asset pricing but for macroeconomics more generally. It is widely believed that these strategies are partly responsible for the high volatility of international capital flows, which are often viewed as problematic by policymakers. Understanding the rationale for widely-used currency strategies is important for understanding exchange rate movements in general, as well as for assessing the normative and positive implications of capital flows.

In a series of papers, we have studied two widely-used currency strategies: carry trade and currency momentum. The carry-trade strategy consists of borrowing low-interest-rate currencies and lending high-interest-rate currencies. The currency-momentum strategy consists of going long (short) on currencies for which long positions have yielded positive (negative) returns in the recent past. One appealing property of these strategies is that a practitioner does not need to estimate any parameters to implement them. One could, of course, entertain more complex versions of these strategies that, for example, optimally weight different currencies, or introduce volatility triggers that reduce exposure at times of high volatility.

This summary reviews our research on these trading strategies. First, we describe the empirical properties of the payoffs to carry and momentum. Second, we discuss whether these payoffs can be viewed as a reward for exposure to conventional types of risk. Third, we explore the plausibility of peso-event-based explanations of the payoffs. Finally, we review our work emphasizing the importance of microstructure frictions and the behavioral biases in understanding currency trading strategies.

Properties of Payoffs to Carry and Momentum

As in all of our work, here we consider a carry-trade strategy that combines individual-currency carry trades into an equally-weighted portfolio. We use the same 20 currencies considered in Burnside, Eichenbaum and Rebelo (2011) [henceforth BER (2011)]. (1) The momentum strategy discussed below combines individual currency-momentum strategies into an equally-weighted portfolio of the same 20 currencies. We implement a monthly version of both strategies. (2) All portfolios are constructed assuming that the U.S. dollar is the domestic currency.

Figure 1 displays the cumulative returns to investing in the carry and momentum strategies and in the U.S. stock market. The investment period spans March 1976 to January 2012. (3) Two features of Figure 1 are worth noting. First, the cumulative returns to both strategies are almost as high as the cumulative return to investing in stocks. Second, the cumulative returns to the stock market are much more volatile than those of the currency portfolios.

[FIGURE 1 OMITTED]

The carry-trade strategy has an average annualized payoff of 4.5 percent, with a standard deviation of 5.2 percent, and a Sharpe ratio (the ratio of the mean excess return to its standard deviation) of 0.86. The momentum strategy is also highly profitable, yielding an average annualized payoff of 4.4 percent. The momentum payoffs have a standard deviation of 7.3 percent and a Sharpe ratio of 0.60.

The Sharpe ratios of both currency strategies are substantially higher than that of the stock market. The average excess return to the U.S. stock market over our sample period is 6.5 percent, with a standard deviation of 15.8 percent and a Sharpe ratio only equal to 0.41.

To an important degree, the high Sharpe ratio of the carry-trade strategy reflects the large gains from diversifying across carry-trade strategies for individual currencies (see Burnside, Eichenbaum, Kleshchelski, and Rebelo (2006), henceforth BEKR (2006)). (4) In our sample, this diversification cuts the volatility of the payoffs by more than 50 percent. Since the average payoff is not affected, the Sharpe ratio of the portfolio doubles relative to the average Sharpe ratio of individual carry trades. (5) Similar gains to diversification obtain for currency momentum.

Surprisingly, the payoffs to the carry and momentum strategies are roughly uncorrelated. So, from an investor standpoint, there are obvious gains to using both currency-trading strategies simulta-neously. Even more striking is the fact that the payoffs to these strategies are uncorrelated with stock market returns. So, the currency-trading strategies provide a natural source of diversification when combined with a broad portfolio of U.S. stocks.

Are the returns to the carry and momentum strategies compensation for measurable risk?

The...