Optimal Factor Strategy in FX Markets
77 Pages Posted: 20 Jun 2016 Last revised: 24 Sep 2018
Date Written: September 9, 2018
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
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