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Are carry, momentum and value still there in currencies?

Journal: International Review of Financial Analysis

Date: 2022

Author: Mark C. Hutchinson, Panagiotis E. Kyziropoulos, John O'Brien, Philip O'Reilly, Tripti Sharma

Abstract:
We show that carry, momentum and value predictability in currencies is associated with mispricing. Specifically, investment performance disappears subsequent to published evidence showing portfolio returns are not fully explained by risk. Replicating these studies, we show that the average out-of-sample Sharpe ratio decreases from +0.39 to -0.32. Cross sectional tests show that currencies no longer respond to interest rate and real exchange rate differentials. During this period currency excess returns do not exhibit autocorrelation. Our results are consistent with investors learning about mispricing from academic research.

Link: Google Scholar

Background and Context

Research Focus

The study investigates whether currency trading strategies based on carry, momentum and value continue to generate profits after academic research reveals their profitability.

Data Sample

Analysis covers 11 major currencies (G11) and 24 peripheral currencies against the US dollar from 1980 to 2020, using exchange rates, interest rates, and economic indicators.

Methodology

The researchers construct currency portfolios using three strategies (carry, momentum, value) and test their performance before and after key academic publications.

Decline in Strategy Performance After Publication

  • Shows how trading strategy returns dramatically declined after being published in academic research
  • All strategies performed positively in-sample but most turned negative out-of-sample
  • Value strategy showed the smallest decline but still dropped significantly

Sharpe Ratio Deterioration Across Strategies

  • Demonstrates the significant decline in risk-adjusted returns (Sharpe ratio)
  • Average Sharpe ratio fell from +0.39 to -0.32 out-of-sample
  • Negative Sharpe ratio indicates strategies are no longer generating risk-adjusted profits

Carry Trade Performance vs Available Carry

  • Shows available carry (interest rate differential) remained positive even after 2008
  • Average monthly carry declined from 0.42% to 0.19% post-2008
  • Poor strategy performance not solely due to low interest rate environment

Momentum Signal Deterioration

  • Shows how momentum signals lost their predictive power
  • R-squared values remain similar but coefficients become insignificant
  • Indicates momentum patterns disappeared after publication

Strategy Break Points Over Time

  • Identifies when each strategy stopped working effectively
  • Momentum failed first (2001), followed by Value (2007) and Carry (2013)
  • Sequential nature suggests gradual market learning

Contribution and Implications

  • Shows currency trading strategies stop working once their profitability is revealed in academic research
  • Suggests returns were due to market inefficiencies rather than fundamental risk factors
  • Has important implications for currency traders and hedge funds using these strategies

Data Sources

  • Performance comparison chart based on Table 2 showing pre- and post-publication returns
  • Sharpe ratio visualization derived from Table 3 cross-sectional test results
  • Carry trade analysis based on data from Figure 1 Panel B
  • Momentum analysis based on Tables 4 and 5 regression results
  • Break point visualization constructed from structural break analysis in Figure 3