Optimal Factor Strategy in FX Markets

64 Pages Posted: 20 Jun 2016 Last revised: 13 May 2018

Thomas Andreas Maurer

Washington University in St. Louis - John M. Olin Business School; London School of Economics & Political Science (LSE)

Thuy Duong To

University of New South Wales, Sydney; Financial Research Network (FIRN)

Ngoc-Khanh Tran

Washington University in Saint Louis - John M. Olin Business School

Date Written: April 24, 2018

Abstract

A mean-variance efficient currency portfolio earns a remarkable out-of-sample Sharpe ratio of 1.21 and has a small downside risk. It dominates popular currency trading strategies both in terms of the Sharpe ratio and the downside risk. Crash risks and popular pricing factors do not explain the performance. There are two key features. First, we use principal component analysis to construct a robust version of the covariance matrix, which reduces estimation errors and significantly improves the out-of-sample performance. Second, market timing -- i.e., trading more (less) aggressively when the conditional risk-return trade-off is more (less) favorable -- significantly increases the unconditional Sharpe ratio and reduces the downside risk.

Keywords: Foreign Exchange, Currency, Carry Trade, Mean-Variance, Estimation Error, Market Timing, Principal Component

JEL Classification: F31, F37, G11, G12, G15, G17

Suggested Citation

Maurer, Thomas Andreas and To, Thuy Duong and Tran, Ngoc-Khanh, Optimal Factor Strategy in FX Markets (April 24, 2018). HKUST Finance Symposium 2016: Active Investing and Arbitrage Capital; 29th Australasian Finance and Banking Conference 2016. Available at SSRN: https://ssrn.com/abstract=2797483 or http://dx.doi.org/10.2139/ssrn.2797483

Thomas Andreas Maurer (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Thuy Duong To

University of New South Wales, Sydney ( email )

School of Banking and Finance,
University of New South Wales
Sydney, 2052
Australia
61295855865 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Ngoc-Khanh Tran

Washington University in Saint Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

HOME PAGE: http://www.olin.wustl.edu/EN-US/Faculty-Research/Faculty/Pages/FacultyDetail.aspx?username=ntran

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