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Economic Momentum and Currency Returns Explained

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Economic Momentum and Currency Returns” navigates the intersection of economic trends and currency returns, unraveling a compelling saga of predictability within the intricate fabric of foreign exchange markets.

Authored by Magnus Dahlquist and Henrik Hasseltoft, this study underscores the profound linkage between past fundamentals, economic activity, and inflation with currency returns.

Their findings culminate in the unveiling of a trading strategy that capitalizes on economic momentum, engendering an annualized Sharpe ratio of 0.70 and yielding a notable alpha when juxtaposed against conventional carry, momentum, and value strategies.

Notably, the economic momentum strategy not only encapsulates the alpha of carry trades but also captures the essence of cross-country disparities in carry, hinting at a multifaceted understanding of currency market dynamics.

With its discourse on carry trade, foreign exchange rates, predictability, and trend following, this paper presents a captivating exploration into the entwined realms of economics and currency returns.

Abstract Of Paper

Past trends in fundamentals linked to economic activity and inflation predict currency returns. We find that a trading strategy that goes long currencies with strong economic momentum and short currencies with weak economic momentum exhibits an annualized Sharpe ratio of 0.70 and yields a significant alpha when controlling for standard carry, momentum, and value strategies. The economic momentum strategy subsumes the alpha of carry trades, suggesting that differences in past economic trends capture cross-country differences in carry.

Original paper – Download PDF

Here you can download the PDF and original paper of Economic Momentum and Currency Returns.

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Author

Magnus Dahlquist
Stockholm School of Economics; Swedish House of Finance

Henrik Hasseltoft
affiliation not provided to SSRN

Conclusion

In conclusion, “Economic Momentum and Currency Returns” unveils a paradigm shift in the domain of currency trading, underscoring the pivotal role of past economic trends in predicting currency returns.

Magnus Dahlquist and Henrik Hasseltoft’s groundbreaking findings illuminate a trading strategy predicated on the notion of economic momentum, boasting an annualized Sharpe ratio of 0.70 and yielding a significant alpha when juxtaposed against conventional carry, momentum, and value strategies.

Notably, the ascendancy of the economic momentum strategy not only eclipses the alpha of carry trades but also tenderly captures the intricacies of cross-country disparities in carry, underscoring the insightful interplay between past economic trends and currency dynamics.

With its discourse on the carry trade, foreign exchange rates, predictability, and trend following, this study presents a compelling denouement that redefines the contours of currency trading strategies.

Related Reading:

Using Option-Implied Information to Improve Currency Carry Trade Profits

Optimal and Naive Diversification in Currency Markets

FAQ

Q1: What is the key finding of the research paper “Economic Momentum and Currency Returns”?

A1: The key finding of the research paper is the profound linkage between past economic trends, economic activity, and inflation with currency returns. The authors introduce a trading strategy based on economic momentum, which involves going long on currencies with strong economic momentum and short on currencies with weak economic momentum. This strategy exhibits an annualized Sharpe ratio of 0.70 and generates a significant alpha, surpassing conventional carry, momentum, and value strategies.

Q2: How does the economic momentum strategy perform compared to traditional carry, momentum, and value strategies?

A2: The economic momentum strategy outperforms traditional carry, momentum, and value strategies. It achieves an annualized Sharpe ratio of 0.70, indicating its effectiveness in capturing risk-adjusted returns. Moreover, the strategy yields a significant alpha, showcasing its superiority over conventional strategies. The economic momentum strategy not only subsumes the alpha of carry trades but also provides insights into cross-country differences in carry, offering a multifaceted understanding of currency market dynamics.

Q3: What does the economic momentum strategy suggest about the role of past economic trends in currency trading?

A3: The economic momentum strategy suggests that past economic trends play a pivotal role in predicting currency returns. By focusing on the economic momentum of currencies based on past economic activity and inflation, the strategy unveils a new dimension in currency trading. The strategy’s ability to capture alpha and outperform traditional strategies underscores the significance of incorporating past economic trends into the analysis of currency market dynamics.

Q4: How does the research contribute to the understanding of the interplay between economics and currency returns?

A4: The research contributes to the understanding of the interplay between economics and currency returns by highlighting the predictive power of past economic trends. The economic momentum strategy introduced in the paper provides a nuanced perspective on currency trading, emphasizing the importance of considering economic factors in addition to traditional strategies. The findings redefine the contours of currency trading strategies and offer valuable insights into the role of economic momentum in shaping currency returns.

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