Maximally Predictable Currency Portfolios

Abstract

We investigate the predictability of the G10 currencies with respect to lagged currency returns from the perspective of a U.S. investor, using the maximally predictable portfolio (MPP) approach of Lo and MacKinlay (1997). Out-of-sample, the MPP yields a higher Sharpe ratio, higher cumulative return and lower maximum drawdown than both an equal-weighted portfolio of the currencies and an equal-weighted portfolio of momentum trading strategies. The MPP has performed particularly well since the 2008 financial crisis, in contrast with the momentum portfolio, the value of which declined significantly over this period. Our results are robust to the estimation window length, the type and level of portfolio weight constraints, and transaction costs.

Keywords: Currencies, Predictability, Trading strategies, Maximally Predictable Portfolio, Momentum and reversals.