Factor Investing in Currency Markets: Does it Make Sense?

107 Pages Posted: 9 Jul 2019

See all articles by Elisa Baku

Elisa Baku

Paris School of Economics (PSE); Université Paris I Panthéon-Sorbonne

Roberta Fortes

Université Paris I Panthéon-Sorbonne

Karine Hervé

Banque de France

Edmond Lezmi

Amundi Asset Management

Hassan Malongo

Amundi Asset Management; Université de Paris-Dauphine (Ceremade)

Thierry Roncalli

Amundi Asset Management; University of Evry

Jiali Xu

Societe Generale

Date Written: June 15, 2019

Abstract

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.

Keywords: foreign exchange rates, factor investing, carry, value, momentum, reversal, interest rate parity, purchasing power parity, BEER, FEER, NATREX, cross-section analysis, time-series analysis, risk premium, basket hedging, overlay management, risk aggregation, alpha strategy

JEL Classification: C50, F31, G11

Suggested Citation

Baku, Elisa and Fortes, Roberta and Hervé, Karine and Lezmi, Edmond and Malongo, Hassan and Roncalli, Thierry and Xu, Jiali, Factor Investing in Currency Markets: Does it Make Sense? (June 15, 2019). Available at SSRN: https://ssrn.com/abstract=3415700 or http://dx.doi.org/10.2139/ssrn.3415700

Elisa Baku

Paris School of Economics (PSE) ( email )

48 Boulevard Jourdan
Paris, 75014 75014
France

Université Paris I Panthéon-Sorbonne ( email )

17, rue de la Sorbonne
Paris, IL 75005
France

Roberta Fortes

Université Paris I Panthéon-Sorbonne ( email )

17, rue de la Sorbonne
Paris, IL 75005
France

Karine Hervé

Banque de France ( email )

Paris
France

Edmond Lezmi

Amundi Asset Management ( email )

90 Boulevard Pasteur
Paris, 75015
France

Hassan Malongo

Amundi Asset Management ( email )

90 Boulevard Pasteur
Paris, 75015
France

Université de Paris-Dauphine (Ceremade) ( email )

Place du Maréchal De Lattre De Tassigny
Paris, 75775
France

Thierry Roncalli (Contact Author)

Amundi Asset Management ( email )

90 Boulevard Pasteur
Paris, 75015
France

University of Evry ( email )

Boulevard Francois Mitterrand
F-91025 Evry Cedex
France

Jiali Xu

Societe Generale ( email )

52 Place de l'Ellipse
La Défense, 92000
France

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