International Finance. Currency Momentum Strategies Essay

International Finance. Currency Momentum Strategies - Essay Example 2. Summary of the article Using time series data of more than 34 years, the paper has examined some important aspects of FX momentum. The article provides an in-depth analysis of the unsystematic and systematic risks, comparing different momentum strategies, describing the importance of transaction costs, sources for non-standard momentum, over and under reaction and the arbitrage limits. The paper has also researched in effect of business cycle risks on currency momentum. 2.1. Fundamentals According to Menkhoff et al (2011, p. 5-8), momentum strategy refers to the trading strategy where an investor seizes an opportunity to ride a rising or a falling trend of the currency market. The basic idea is that an investor will take a long position for a basket of currency that shows an increasing trending price or a short position that sees a decreasing price. Momentum trading is done with the belief that once a trend is established, it will continue in the same direction for some time befor e stabilising and then reducing. If one sells when the prices are showing a decreasing trend, then the trader is taking a short position and he wants to reduce the losses and exit the currency before it reaches the bottom. If the trader buys when the price is showing a rising trend, then he is taking a long position and by buying when the trend is rising, the investor can hope to make more profits since he hopes the price will continue to rise. In both cases of long and short position, there is an upward and a downward momentum. This principle holds true for the all types of trading markets such as stocks, bonds, property, commodity, bullion and other markets that sees volatility in the markets and traders make profits on an hourly basis by seizing and riding the opportunity trend (Menkhoff et al, 2011, p. 8). 2.2. Data and Portfolio formation While earlier studies have focussed on single time series currency, the research by Menkhoff et al (2011, p. 9-12) uses cross sectional curre ncy. This means the relations and momentums of 48 different currencies are considered. By considering a period of 34 years, one can see a better return variation over time for the currencies. This also allows better accounting for transaction cists and helps to understand the limits of arbitrage. Data were obtained from databases of Reuters and BBI for the spot and forward rates for end of month data. Total observations made were 9,043. 2.3. FX momentum Strategies Different test strategies were selected for the study. These are features currency momentum strategies, stability of strategies for out of sample tests, differences in trading rules, carry trades and currency momentum and long-term behaviour (Menkhoff, et al, 2011, p. 14-15). The strategies as reported by Menkhoff et al (2011, p. 15-26) showed different test behaviour, Momentum strategies provide high returns of 6-10% for holding durations of a month and then they reduce when the holding period is increased and profitabili ty comes from spot rate changes. By using different cross section of currencies, it is seen that gain decrease when a large cross section of currencies is selected. The authors run the tests to compare momentum of trading rules where three-benchmark averages cross over rules were used. These strategies showed profits of more than 5% with high annual Sharpe Ratios, however, there were variations in the returns. Hence, the relation of currency momentum to benchmark technical trading strategies is not close. It was also