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Currency Momentum Strategies

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Currency Momentum Strategies” authored by Lukas Menkhoff, Lucio Sarno, Maik Schmeling, and Andreas Schrimpf provides a comprehensive empirical investigation of momentum strategies within the foreign exchange market.

The study reveals a substantial cross-sectional spread in excess returns of up to 10% per annum between past winner and loser currencies. Impressively, the observed spread in excess returns eludes explanation by traditional risk factors, though it is partially explicated by transaction costs and displays behavior that aligns with investor under- and over-reaction.

Notably, the research underscores that cross-sectional currency momentum possesses distinct properties from the extensively examined carry trade and exhibits minimal correlation with the returns of benchmark technical trading rules.

Evidently, the study sheds light on the effectiveness of limits to arbitrage, elucidating the constraints that impede the facile exploitability of momentum returns in currency markets.

This comprehensive investigation enriches our understanding of the complex dynamics that underpin currency momentum strategies, advancing our comprehension of the intricacies of foreign exchange trading.

Abstract Of Paper

We provide a broad empirical investigation of momentum strategies in the foreign exchange market. We find a significant cross-sectional spread in excess returns of up to 10% p.a. between past winner and loser currencies. This spread in excess returns is not explained by traditional risk factors, it is partially explained by transaction costs and shows behavior consistent with investor under- and over-reaction. Moreover, cross-sectional currency momentum has very different properties from the widely studied carry trade and is not highly correlated with returns of benchmark technical trading rules. However, there seem to be very effective limits to arbitrage which prevent momentum returns from being easily exploitable in currency markets.

Original paper – Download PDF

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Author

Lukas Menkhoff
German Institute for Economic Research (DIW Berlin); Humboldt University of Berlin – Faculty of Economics

Lucio Sarno
University of Cambridge – Judge Business School; Centre for Economic Policy Research (CEPR)

Maik Schmeling
Goethe University Frankfurt – Department of Finance; Centre for Economic Policy Research (CEPR)

Andreas Schrimpf
Bank for International Settlements (BIS) – Monetary and Economic Department; Centre for Economic Policy Research (CEPR); University of Tuebingen

Conclusion

In conclusion, the research paper “Currency Momentum Strategies” authored by Lukas Menkhoff, Lucio Sarno, Maik Schmeling, and Andreas Schrimpf offers a nuanced empirical examination of momentum strategies within the foreign exchange market.

The study’s findings unveil a remarkable cross-sectional spread in excess returns, with divergences of up to 10% annually between past winner and loser currencies. This observed spread eludes explication by traditional risk factors, though it is partially attributed to transaction costs and exhibits behavioral patterns synonymous with investor under- and over-reaction.

Furthermore, the research underscores the distinct properties of cross-sectional currency momentum, juxtaposing it against the commonly studied carry trade and revealing its minimal correlation with benchmark technical trading rules. The study elucidates the striking effectiveness of limits to arbitrage in impeding the exploitability of momentum returns in currency markets.

This comprehensive investigation furnishes a deeper understanding of the intricate dynamics governing currency momentum strategies, contributing to our comprehension of the complexities inherent in foreign exchange trading.

Related Reading:

A New Look at Currency Investing

Yield Curve Predictors of Foreign Exchange Returns

FAQ

Q1: What is the main focus of the research paper “Currency Momentum Strategies” by Lukas Menkhoff, Lucio Sarno, Maik Schmeling, and Andreas Schrimpf?

A1: The main focus of the research paper is to provide a broad empirical investigation of momentum strategies in the foreign exchange market. The study explores the cross-sectional spread in excess returns between past winner and loser currencies, aiming to understand the factors contributing to this spread and how it differs from traditional risk factors.

Q2: What significant finding does the study reveal about the cross-sectional spread in excess returns of past winner and loser currencies?

A2: The study reveals a substantial cross-sectional spread in excess returns of up to 10% per annum between past winner and loser currencies. This spread is noteworthy because it cannot be explained by traditional risk factors, though it is partially attributed to transaction costs. The observed behavior aligns with investor under- and over-reaction.

Q3: How does cross-sectional currency momentum differ from the carry trade, and what is its correlation with benchmark technical trading rules?

A3: The research underscores that cross-sectional currency momentum has distinct properties from the widely studied carry trade. It exhibits minimal correlation with returns of benchmark technical trading rules, highlighting its unique characteristics within the foreign exchange market.

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