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Optimal Factor Strategy in FX Markets

96 Pages Posted: 20 Jun 2016 Last revised: 7 Dec 2017

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: September 18, 2017

Abstract

A mean-variance efficient currency trading strategy, which mimics the inverse of the minimum variance stochastic discount factor, earns a remarkable out-of-sample Sharpe ratio of 1.17 before and 0.91 after transaction costs. It substantially outperforms other popular currency strategies across diverse performance measures and sub-samples. Crash risk and popular pricing factors do not explain the superior performance. The strategy predicts future returns, market volatility and illiquidity. A pricing model with the strategy as a single factor outperforms and subsumes the popular “Dollar”-“Carry” two factor model and the downside risk and intermediary asset pricing factors. A key feature of the strategy is market timing, i.e., dynamic adjustments of its risk exposure in response to time variations in market prices of risk (but not necessarily market volatility), which enhances its unconditional Sharpe ratio.

The online appendix may be found at: http://ssrn.com/abstract=2837851.

Keywords: Foreign Exchange, Mean-Variance, Minimum Variance SDF, Factor Pricing Model, Dollar, Carry, Maximum Sharpe Ratio, Predictability, 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 (September 18, 2017). 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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