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Factor Investing in Currency Markets: Does it Make Sense?
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The concept of factor investing emerged at the end of the 2000s and has completely changed the landscape of equity investing. Today, institutional investors structure their strategic asset allocation around five risk factors: size, value, low beta, momentum and quality. This approach has been extended to multi-asset portfolios and is known as the alternative risk premia model. This framework recognizes that the construction of diversified portfolios cannot only be reduced to the allocation policy between asset classes, such as stocks and bonds. Indeed, diversification is multifaceted and must also consider alternative risk factors. More recently, factor investing has gained popularity in the fixed income universe, even though the use of risk factors is an old topic for modeling the yield curve and pricing interest rate contingent claims. Factor investing is now implemented for managing portfolios of corporate bonds or emerging bonds. In this paper, we focus on currency markets. The dynamics of foreign exchange rates are generally explained by several theoretical economic models that are commonly presented as competing approaches. In our opinion, they are more complementary and they can be the backbone of a Fama-French-Carhart risk factor model for currencies. In particular, we show that these risk factors may explain a significant part of time-series and cross-section returns in foreign exchange markets. Therefore, this result helps us to better understand the management of forex portfolios. To illustrate this point, we provide some applications concerning basket hedging, overlay management and the construction of alpha strategies.
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From the onset of the euro crisis to the Brexit vote, we have witnessed impressive reductions of current account imbalances in peripheral countries of the euro area. These reductions can be the result of either a compression of internal demand or an improvement in external competitiveness. In this paper, we compute exchange rate misalignments within the euro area to assess whether peripheral countries have managed to improve their external competitiveness. After controlling for the reduction of business cycle synchronization within the EMU, we find that peripheral countries have managed to reduce their exchange rate misalignments thanks to internal devaluations. To some extent, these favourable evolutions reflect improvements in external competitiveness. Nevertheless, these gains could only be temporary if peripheral countries do not improve their non-price competitiveness, their trade structures and their international specializations in the long run.
Abbreviations: EMU, European Monetary Union; FEER, Fundamental Equilibrium Exchange Rate; SMIM, Symmetric Matrix Inversion Method; BEER, Behavioural Equilibrium Exchange Rate; PPP, Purchasing Parity Power; OCI, Own Country Included; IMF, International Monetary Fund; OECD, Organisation for Economic Co-operation and Development; NIESR, National Institute of Economic and Social Research.
We develop an empirical model of bilateral exchange rates. It includes normal shocks with stochastic variance and jumps in an exchange rate and in its variance. The probability of a jump in an exchange rate corresponding to depreciation (appreciation) of the U.S. dollar is increasing in the domestic (foreign) interest rate. The probability of a jump in variance is increasing in the variance only. Jumps in exchange rates are associated with announcements; jumps in variance are not. On average, jumps account for 25% of currency risk. The dollar carry index retains these features. Options suggest that jump risk is priced.
Aggregate consumption growth risk explains why low interest rate currencies do not appreciate as much as the interest rate differential and why high interest rate currencies do not depreciate as much as the interest rate differential. Domestic investors earn negative excess returns on low interest rate currency portfolios and positive excess returns on high interest rate currency portfolios. Because high interest rate currencies depreciate on average when domestic consumption growth is low and low interest rate currencies appreciate under the same conditions, low interest rate currencies provide domestic investors with a hedge against domestic aggregate consumption growth risk.
