The Value of Volume in Foreign Exchange
This article proposes the primary research question: does FX volume contain information that is statistically and economically relevant for understanding future currency returns? The findings suggest that low volume tends to correspond with prices reversals. It could be assumed that this indicates high levels of informed trading because traders are not eager to place trades indicating they may be uncertain or believe prices may reverse. The findings show the effect is strongest for spot currency trades and the weakest for swap contracts. When volume is high the reversal effect is reduced.
A panel regression is used to analyze the relationship between currency returns and FX volume and the results indicate that FX volume is a key determinant of future currency returns. A portfolio approach is used to test the economic significance and indicates that returns on low-volume currency pairs are expected to reverse, while returns on high-volume currency pairs are expected to be lower. From these results a strategy, termed RevL, is formed. RevL has a long (short) position in currency pairs with low (high) prior returns, from the perspective of the base currency as well as low FX volume. The strategy is tested and has a 19% annual return with a Sharpe ratio of 1.82.
Through further testing, it is discovered that the RevL strategy does not correlate with other popular FX trading strategies (momentum, value and carry) and actually offers attractive diversification opportunities for these strategies. Lastly a bootstrap procedure is used to generate p-values for various measures of investment performance to test the null hypothesis that past volume nor past returns do not have predictive ability. The results of the test indicate that there is a high statistical significance between FX volume and returns. Click here to read the full article by Gargano, Riddiough and Sarno.
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