Strategy Diversification: Combining momentum and carry strategies within a foreign exchange portfolio
The main research question of this article is whether there is value in combining technical and macro/fundamental strategies. Two strategies are tested individually, then three variations of the combined strategies are tested and compared to the returns of two indices, the S&P500 and the BTOP50, to determine if their combination leads to an improvement in risk-adjusted returns. The strategies used are two common foreign exchange trading strategies– the momentum strategy and the carry strategy. Data from the 20-year period 1993-2013 on eight of the major currencies is used.
The first trading strategy, momentum, relies on the existence of sustainable price trends. These trends are driven by an increase in liquidity demands, which can be caused by increased market risk (as greater hedged risk leads to greater demand) as well as the buildup of large speculative position. The strategy goes long (short) when the currency’s 20-day moving average of the closing price crosses above (below) its 120 day moving average. This strategy has attractive long-term returns and an annual return of 7%. The macro/fundamental strategy is a carry strategy, which ranks each currency based on the county’s three-month deposit rate yield and takes long (short) positions in the three highest (lowest)-yielding currencies. This strategy also yields positively, returning about 5.35% per year.
Once each strategy’s individual returns are found, the two strategies are combined in order to create a strategy with a better risk-adjusted return. Three approaches are compared: an equal-weighted portfolio, a minimum risk portfolio, and a mean-variance maximization portfolio. Two of the three produced risk-adjusted returns that are superior to the individual strategies—the equal weighted approach and the minimum risk approach resulted in better risk-adjusted returns, while the utility maximizing portfolio performed poorly. When volatility is factored in, the equal-weighted combination outperforms both independent strategies. Read the full article by Francis Olszweski and Guofu Zhou here.
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