We live in a world that is shaped by forecasts. In every field of human activity forecasts target the programme in the future. Weather forecast, traffic forecasts, predictions of life expectancy, forecast of birth, expectation of use, forecast of demand and so on. In today’s world, technology has become more accessible, making predictions using sophisticated tools has become easier. Economic differences between countries such as national income, money growth, inflation and trade balances, are factors that influence the demand and supply of currencies and therefore also the FX prices in the medium to long term. However there’s no definitive evidence that any economic variable can forecast exchange rates. Academics found that a “random walk” model (i.e. a “monkey- model”) is just as good at predicting exchange rates as models based on fundamentals(1).
Can some metrics at least help shaping a probabilistic scenario for exchange rate movements? Today’s financial practice and some recent research supports the idea that exchange rates behave like many other financial assets, whose price movements can be correlated to Momentum and Value indicators(2).
Momentum is defined as a positive or negative performance in a certain period of time. The idea of momentum is that the price is more likely to keep moving in the same direction than to change directions. The trend decides on investment choices: if the trend is positive, it will continue to be so and vice versa. A standard, popular metric for momentum is the past 12-month cumulative raw return. Hence, if the past 12-month performance is positive, there are good chances it will stay positive in the next future. Short-term momentum, e.g. past 3-month cumulative raw return, is rather popular, too.
Another Momentum following methodology is the 200 vs 20 days Simple Moving Average, that is based on a rule such as:
• buy when the 20 days moving average > 200 days moving average;
• sell when the 20 days moving average < 200 days moving average.
Momentum following methods are heavily utilized in the Futures arena: many global macro hedge funds use these simple rules.
Hence momentum can be thought of as the latent strength of the force behind the underlying trend. Momentum seems a silly idea, but it works, and it is most often explained by behavioural finance: it is all about “herding” mechanism – i.e. investors follow the crowd, hence trends tend to persist.
The main idea of Value strategies is that currencies can be considered “cheap” or “expensive” if compared with their real (or supposed to be) value.
Exchange rates display “mean reversion behaviours”: temporary high and low prices will tend to go back to the long term average over time.
In other terms, momentum it’s ok, but nothing can go up (or down) forever.
The simplest value metric for currencies is the so called reversal: the price of 5 (or 10) years ago divided by the most recent price. The rule is, again, very simple:
• buy when value 5 (or 10) years ago > today’s price;
• sell when value 5 (or 10) years ago < today’s price.
In practice instead of using the historical price, it is common to adopt an average of 20 daily prices in order to reduce the effect of anomalous prices.
3. COMBINING VALUE AND MOMENTUM
Trends do exist, but they do not last forever; at that point the “mean reversion” effect dominates. Thus combining Value and Momentum indicators is an appealing idea. Quantitatively, this strategy actually performs better in foreign exchange markets than in equity markets.
Let us examine current FX markets using a combination of Momentum and Value indicators:
a. 200 vs 20 days Simple Moving Average;
b. short term momentum (3-months performance); c. long term momentum (12-months performance).
- medium term average reversal (5 years);
- long term average reversal (10 years).
Figure 1 shows the buy-sell signals for a number of currencies vs the US dollar, as of October 3rd, 2014.
From a simple visual inspection of the table, some patterns emerge as quite significative; for example the strength of the US dollar appreciation vs euro. Of course, there are several potential events that may adversely impact the result of a value-momentum analysis: political uncertainty, risk contagion episodes, and other macro-factors. Such events have the potential to cause the exchange rate to diverge from the signal of the value-momentum analysis.
Value and momentum in the FX markets have captured the attention of financial practitioners and academics due to their statistical and economic significance.
Using a combination of value and momentum indicators can be interesting because it provides a powerful indication about the strength or the weakness of a currency: a useful indication when facing currency hedging decisions.
In the today’s complex reality, the behaviours often depend on analysis of forecasts.
It’s certainly indisputable that it is not possible to quantify the future but there are technologies and tools that use the numbers to increase understanding and evaluation of the risks. Thanks to advances in the understanding of risk is now possible to make rational decisions.
But be careful. Sometimes it is good to remember that predictions are only tools and should not become “oracles”
“It’s hard to make predictions, especially about the future”, Niels Bohr, Nobel Prize in Physics in 1922.
Authors: Laura Oliva, Raffaele Zenti
1 L. Kilian, M. P. Taylor, (2008) “Why Is It So Difficult to Beat the Random Walk Forecast of Exchange Rates?”, Journal of International Economics, vol. 60. “Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?” by Richard A. Meese and Kenneth Rogoff, Journal of International Economics 14, February 1983, pp. 3–24.
2 C. S. Asness, T. J. Moskowitz, L. H. Pedersen, (2013) “Value and momentum everywhere”, The Journal of Finance, vol. 68.