Essay: Carry Trade VS. Momentum

Introduction

This paper is written to investigate the investments strategies Carry Trade and Momentum. The plausibility of the theories proposed in the literature will be assessed to explain the profitability of these strategies. The carry trade consists of borrowing low–interest rate currencies and lending high–interest rate currencies. The momentum strategy consists of going long (short) on currencies for which long positions have yielded positive (negative) returns in the recent past (Burnside, 2011). The main question of this research review is:

What investment strategy between Carry Trade and Momentum is the most profitable?

There are many different strategies that ensure that currency risk is minimized. Two of those strategies will be argued in this paper. These strategies have received a great deal of attention in the academic literature as researchers struggle to explain its apparent profitability. Another reason why these two strategies has been chosen, is because the average investor is overloaded with different types of strategies, who all claim that they are the best strategy to use for investing. This paper has chosen two common strategies to refute, to make the choice for an investor easier.

The Carry Trade and Momentum strategies will be examined by using different kinds of academic literatures. In related work, several authors have studied the properties of currency strategies. In this paper there are also various studies discussed from different authors.

The literature review will focus on the profitability of these two kinds of strategies. The first chapter of this paper will introduce the general terminology behind Carry Trade and Momentum including the benefits and risks per strategy. This general information gives an idea of the different strategies, which will provide a basis for answering the main research question. The second part of the paper will consist of the literature survey which is related to different journals. The most important findings of different authors will be used for this paper. Those finding will be compared to each other in chapter four and from which a conclusion will be formed. Finally, the last chapter will include a summary of the previous chapters and it will conclude this review by giving an answer to the main research question.

Overview

In this review we describe the payoffs to two currency speculation strategies: the carry trade and momentum.

Carry Trade

One of the most used and oldest currency speculation strategies is the Carry Trade (Fritzmann, 2017). The Carry Trade is an attempt to take advantage of deviations from uncovered interest parity (UIP). The UIP is a non-arbitrage condition. It postulates that the nominal interest differential between two countries should be equal to the expected depreciation of the exchange rate and assumes perfect capital mobility (surveys of the literature on UIP (Hodrick, 1987) and (Engel, 1995)). In this literature research traders borrow a currency that has a low interest rate and use the funds to buy a different currency. This currency is paying a higher interest rate, is documented by (Bilson, 1980) and (Fama, 1984). Currency Carry Trade could be implemented to determine which currency offers a high yield and which currency offers a lower yield so you can buy low and sell high. This strategy receives a lot of interest of the academic literature.

The calculation of carry trade is described in the literature of (Burnside, 2011) as follows:

Assume that the domestic currency is the U.S. dollar (USD) and denote the USD risk-free rate by it . Let the interest rate on risk-free foreign denominated securities be it. Abstracting from transactions costs, the payoff to taking a long position on foreign currency is:

Z_(t+1)^L=(1+i_t^*) (S^t+1)/S^t -(1+i_t)

Here St denotes the spot exchange rate expressed as USD per foreign currency unit (FCU). The payoff to the carry trade strategy is:

Z_(t+1)^C=sign(i_t^*-i^t) Z_(t+1)^L

An alternative way to implement the carry trade is to use forward contracts. We denote by Ft the time-t forward exchange rate for contracts that mature at time t +1, expressed as USD per FCU. A currency is said to be at a forward premium relative to the USD if Ft exceeds St. The carry trade can be implemented by selling forward currencies that are at a forward premium and buying forward currencies that are at a forward discount. The time t payoff to this strategy can be written as:

Z_(t+1)^F=sign(F_t+S_t) (F_t-S_(t+1))

It is easy to show that, when covered interest parity (CIP) holds, The CIP situation means there is no opportunity for arbitrage using forward contracts, which often exists between countries with different interest rates. These two ways of implementing the carry trade are equivalent in the sense that are proportional.

So, whenever one strategy makes positive profits so does the other. Taking transactions costs into account, deviations from CIP are generally small and rare. (Burnside, 2011).

Benefits

As a trader, a conscious choice is made to act with a strategy. To make the right choice, the advantages and disadvantages have to be known. The benefits of the Carry Trade are shown in this paragraph.

If the currency stays stable during the time you are in the Carry Trade, you will earn interest profit. If the price of currency moves in your favour during the time you are in the carry trade, you will receive interest along with the value increase of the currency pair. These are some ways to take advantage of the Carry Trade. If the currency stays stable during the time you are in the Momentum, you will not earn profit, only if the price of currency moves in your favour.

In the case of the dollar Carry trade strategy it is highly profitable. This can be explained by the average forward discount on foreign currencies of developed countries against the dollar forecast basket-level exchange rate changes and returns. (Lustig, Roussanov, & Verdelhan, Countercyclical currency risk premia, 2014)

A downside of the Carry Trade is currency risk, this can be minimalized by forward contracts. A forward contract means according to (Burnside, 2011) a customized contract between two parties to buy or sell an asset at a specified price on a future date. This creates certainty about the exchange rate that will be received when exchanging the different currencies. These contracts can be used to cover a part of the currency risk, but will lower the overall profit.

Risks

While the carry trade investment strategy is one of the most widely used strategies, it is important to note that it does have certain weak points. This author (Dobrynskaya, 2013) suggest that the Carry Trade strategies are only appropriate for deep-pocketed entities because of two major risks: the risk of a sharp decline in the price of the invested assets and the implicit exchange risk when the funding currency differs from the borrower’s domestic currency.

It is known that carry trades are lackluster in highly volatile environments, as is shown by (Menkhoff, Sarno, Schmeling and Scheimpf, 2012), (Burnside, Eichenbaum, Kleschelski, and Rebelo, 2011), (Clarida, Davis and Pedersen, 2009) and (Bhansali, 2007). These papers claim that the average return is much worse during times of high volatility and can even be negative. Furthermore, (Brunnermeirer, Nagel, and Pedersen, 2009) claim that the Carry Trade has a negative skewness based on their empirical study. This conclusion was reached by their findings of a negative correlation between interest rate differentials and skewness, which shows that Carry Trades are susceptible to negative skewness. Negative skewness indicates that overall there are more chances of extreme negative results then positive ones. To summarise, the paper finds that the Carry Trade portfolios have large Sharpe ratios, negative skewness and positive excess kurtosis. This indicates that the Carry Trade is on average profitable but it does have a crash risk and fat tails.

Risk factors on the Carry Trade is a topic which is debated quite frequently in the academic community. The debate is mainly about whether or not the Carry Trade is susceptible to the standard risk factors. One view from (Burnside, 2011) claims that standard risk factors do not work, because the traditional risk factors used to price the stock market are not applicable to pricing currency returns. This conclusion is based on the fact that the covariance between the payoff and convention risk factors is not statistically significant. (Bekaert & Hodrick, 1992) (Backus, Foresi, & Telmer, 2001)The author finds that less traditional factors, such as currency fluctuations are having more success in explaining currency returns. However, these less traditional factors do not seem to work for explaining the returns on the stock market.

The other side of the debate finds that there is a variety of risk factors for the carry trade. There are several papers which find empirical support for this argument. (Dobrynskaya, 2014) and (Lettau, Maggiori, and Weber, 2014) both find that an average return on high interest rate currencies can be by their high conditional exposure to the market when it is in a down state. (Ranaldo and Soderlind, 2010) claim that some currencies have ‘safe haven’ attributes. These attributes are defined as the following: a currency that appreciates when market risk and liquidity increase and benefits from negative exposure to risky assets. The paper written by (Menkhoff, Sarno, Schmeling and Schrimpf, 2012) argues that the carry trades are vulnerable to a global FX volatility risk. They find that high interest rate currencies are negatively correlated when it comes to innovations in global FX volatility, which then leads to low returns in times of unexpected high volatility. The low interest rate currencies are then providing a hedge by providing positive returns. This links back to the papers mentioned before about the performance of the carry trade in highly volatile environments. Besides these kinds of risks there is also the unexpected risk of differing opinions of investors, which is argued by (Beber, Breedon and Buraschi, 2010). This paper concludes that the degree of difference of beliefs explains the results for the US dollar and Japanese yen currency pair. This means that a yen-dollar trade performs poorly when the is a large difference of opinion between the various investors.

The carry trade clearly has its downsized and risks associated with it. Furthermore, it is clear that the performance of the carry trade is worse in times of high volatility. There is still a large amount of debate or whether or not the carry trade is susceptible to standard risk factors such as, market and financial risk.

Momentum

The currency momentum trade measures the rate of speed in which a course moves in a certain direction. By measuring the difference between the current price and the price of the same instrument an X number of days ago and then dividing this by the current rate, the trader gets an indication of the strength of a trend (Menkhoff, 2011b). Research has shown that momentum trading works well and that this indicator can be used to act on. In particular, a lot of academic research has been done into the momentum effect on equities and currencies.

The calculation of momentum is described in the literature of (Burnside, 2011) as follows:

The calculation of the momentum strategy involves selling (buying) a FCU forward if it was profitable to sell (buy) a FCU forward at time t-T. Following (Menkhoff, 2011b) (Moskowitz, 2010) (Rafferty, 2010) (Lustig, 2009), (Burnside, 2011) define momentum in terms of the previous month’s return, what means that they have chosen for T =1. The excess return to the momentum strategy is:

Z_(t+1)^M=sign(Z_t^L) Z_(t+1)^L

(Burnside, 2011) Considers momentum trades conducted one currency at a time against the U.S. dollar.

Benefits

What does the momentum mean? In the 17th century, Isaac Newton said “In an inertial frame of reference, an object either remains at rest or continues to move at a constant velocity, unless acted upon by a force.” This physical law also appears to apply to today’s financial markets: shares that have performed well, generally also perform better. The reverse applies to shares that are left behind.

The data you need to invest trough the Momentum is easy to obtain. As mentioned earlier, the main information that is needed to calculate the Momentum is the trend of the currency. This is the most important factor to determine which different currencies are the most profitable for trading.

An investor who follows the momentum strategy assumes that a trend that has started, will continue in the future. Multiple explanations substantiate this thought. The most cited explanation is that people take decisions when they in reality are guided by the choices of other people. This is called “herding behaviour” (Grinblatt, 1995). When investors thus observe that the price of a certain share is driven up, the people around them (other investors) start to buy that share, they will be inclined to participate go and buy this share too. This increases the price of the share further and more and more people will notice the trend. It is not unlikely that the financial press also paid attention to the advance of the share. This has as a result, even more people will be inclined to buy the share, what the price in its turn to rise even further. When investors perceive that one negative trend is being deployed and that more and more people are taking the share of the start handing, these too will be inclined to do the same. This has as result that the price will drop further so that even more people will see the negative trend notice and tend to also sell their shares. These actions let the price drop further again. (Fama, 1996)

Another explanation indicates that people need time for new information to assimilate. When there is good news regarding a certain company, the price of their shares will normally rise. It is however, only after some time that the total impact of this good news can be realized. When the investors realize that an even higher price can be achieved. The price will thus be driven even higher by this rising awareness. The reverse happens when bad news reaches the market. This is indicated in the financial economy by the under reaction hypothesis. (Fama, 1996)

A third statement states that the market may overreact. It is possible to accumulate significant momentum yields before the market itself corrects and the trend reverses. If the behaviours outlined above actually occur in the financial markets, an investor can profit from buying (selling) shares that have risen (dropped). This strategy can be articulated in the sense: “Buy high, sell even higher.” (Fama, 1996)

Also, research showed that an important anomaly is momentum. Stocks with a bad result over the past few years tend to have a bad result in the coming months. And vice versa for rising stocks, which tend to continue to rise (Fama, 1996). In contrast to the extensive literature on momentum strategies in stock markets, the literature on currency momentum has mostly developed a somewhat different line of research. The most striking difference is the fact that currency momentum studies generally do not analyse momentum in a cross-section of currencies but in the time series of single exchange rates, often framed as “technical trading rules.” (L. Menkhoff, 2007). This time-series literature has extensively examined which kinds of momentum trading rules work best. However, there is not enough evidence on cross-sectional aspects of currency momentum. One exception is (John Okunev, 2003) which analyses a universe of eight currencies over 20 years, from January 1980 to June 2000. At the end of each month, the investor goes long in the currency with the best last-month performance and goes short in the currency with the worst last-month performance. This yields a return of about 5-6% per year, which is largely independent of the base currency chosen and of the specific trading rules chosen, what means how exactly the best and worst currencies are identified. Thus, there is clear indication that currency momentum strategies may be profitable and thus worthy of a thorough examination. (Burnside, 2011)

Risks

Momentum is an investment strategy that is widely debated when it comes to the explanation for its premium. These explanations can be categorized as risk-based models and behavioural theories. Standard risk-based models such as the Fama-French three factor model and CAPM have not clearly demonstrated the momentum returns. (Jegadeesh, Titman, 2001) In a recent study by (Grobys,Heinonen and Kolari, 2018) they investigate the possibility of a link between currency momentum and economic risk, which is measured as by currency return dispersion. They claim that based on their evidence and checks that there is a case to be made for the explanation of currency momentum profits with global economic risk.

On the other hand, behavioural models find that the momentum returns are based on either an underreaction or a delayed overreaction. These models relate this to market inefficiencies which provide an opportunity for investors to make a profit. (Barberis, Shleifer, Vishny, 1998) (Hong, Stein, 1999) There is still no general consensus on which argument is correct.

However, there seems to be much confusion and debate when it comes to the momentum trading strategy. (Asness, Frazzini, Isreal, and Moskowitz, 2014) attempt to clear up much of this confusion by documenting what is known about the momentum and debunking some of the popular myths. One of these myths is that there is no theory behind momentum. This is largely due to the fact that there is still no consensus on theories explaining momentum. The author (Asness, Frazzini, Isreal, and Moskowitz, 2014) attempt argues that there are several reasonable theories. (Avramov, Chordia, Jostova, Philipov, 2007)

When compared to the stock market the currency market is much more liquid. This means that there is a larger volume of transaction and much lower transaction costs. There are also no short-selling limitations, which means that the shorting of past underperforming assets is easier. The hurdle for generating high returns with momentum is raised when contemplating currency markets. Momentum profits are highly time-varying, which can be a problem for investors in the currency markets who have short-term targets. Currency momentum returns are not driven by policy measures of countries. The returns from currency momentum primarily come from currencies that are difficult to hedge and have a significant country risk. (Menkhoff, Sarno, Schmeling, Schrimpf, 2012) This is similar to the findings that equity momentum is prevalent in stocks with high credit risk. (Avramov, Chordia, Jostova, Philipov, 2007)

To summarize, the currency momentum is still a much debated model for investing. There is no general consensus when it comes to explaining the premia. There are arguments for both sides, standard risk-models and behavioural models. There are also a lot of misconceptions and myths surrounding the momentum investing strategy. These have been cleared up by (Asness, Frazzini, Isreal, and Moskowitz, 2014). Furthermore, momentum profits are highly time-varying, which can be an issue if an investor has short term targets.

Carry Trade vs. Momentum

This chapter will compare the benefits and risk of the two strategies. By compering these two strategies it is possible to give answer on the mean question ‘What investment strategy between Carry Trade and Momentum is the most profitable?’

Benefits

The Carry Trade and the Momentum can be used in different markets, which makes it difficult to compare those two strategies with each other. To make a comparison possible, it is assumed that both strategies are investing in the currency trade.

The Momentum strategy operates by following a trend. It presumes that once a trend has started, it will continue in the future. So, at the Momentum, investments are made based on the expectations. These expectations can never be determined with 100% certainty within the economic world. If currency A rises in relation to another currency (B), traders must invest in currency A according to the Momentum. Currency A can continue to rise, but can also get a blow and suddenly fall.

Within the Carry Trade, investments are also made on the basis of the expectation. For example, assuming that a trader borrows in Japan with 0.5% interest and this borrowed amount is deposited in the US for a 4% interest rate. It is assumed that the exchange rate between the Dollar and the Yen will remain the same or will change positively compared to the Yen. If the expectation in this example is, that the rate between the Dollar and the Yen will remain the same, the profit will be equal to 3,5%. If the currencies change positively (the Dollar decrease or the Yen increase) it will also positively impact the profit.

The most obvious risk which both strategies relate to, is when the market changes negatively, it has negative consequences on both strategies. The difference between the examples, is that the Carry Trade can also guarantee a profit if the currency rate stays the same. The Momentum depends on one factor (variable), while the Carry trade depends on two factors. The only dependent factor for the momentum is currency rate. As an individual you have no influence on the trend of currency trade. The currency risk can be minimalized by forward contracts. The downside of using forward contracts is that you can miss out on profit.

The first variable of the Carry Trade is interest and the second one is currency rate. The first variable (depending on the type of loan) is fixed. The second one is not, but also in this case there are different kinds of ways to minimalize currency risk. So if the interest and currency rate stays the same, then only the Carry Trade will be profitable. In this case being dependent on two factors imposes less risk then being dependent on one.

Therefore, it can be concluded that with the right options the Carry Trade imposes less risk of losing money than with the Momentum. A disadvantage is that more effort has to be made for investing based on the Carry Trade. In addition to finding out in which foreign currency the best investments can be made to obtain the highest possible profit, the interest rates of different countries must also be compared.

Return on investment

The paper by (Burnside et al. 2011) provides a summary of statistics for the payoffs between the Carry Trade and Momentum strategies for 20 major currencies, over the period from 1976 to 2010. In their findings, the size of the bet is normalized to one USD. The paper compares individual currency strategies and portfolio strategies.

Figure 1: Annualized excess returns of investment strategies (1976-2010) (Burnside et al. 2011)

Carry Trade

The results for the Carry Trade with an individual currency is a payoff of 4.6%, with a standard deviation of 11,3% and a Sharpe ratio of 0.42. Next, they show the average payoff averaged across the 20 currencies. This results in a payoff of 4.6%, with a standard deviation of 11.3% and a Sharpe ratio of 0.89. The Sharpe ratio of the portfolio strategy is more then twice as large as the individual strategy. This is entirely attributable to the gains of diversification by investing in a large basket of currencies. This cuts volatility by more than 50%. The results also show that the Carry trade has a negative skewness which indicates that it is susceptible to crash risk.

Momentum

The individual strategy results for the Momentum strategy is as follows, a payoff of 4.9%, with a standard deviation of 11.3% and a Sharpe ratio of 0.43. The portfolio strategy for the Momentum strategy yields a payoff of 4.5% with a standard deviation of 7.3% and a Sharpe ratio of 0.62. Just as the Carry Trade, Momentum can benefit from diversification. The Momentum strategy shows a positive skewness. Positive skewness is usually preferred over negative skewness, because investors want to avoid a chance of an extreme negative result.

It is clear that the Momentum strategy has higher returns when it comes to individual strategies but in the case of portfolios, Carry Trade is the clear winner. This is because of the higher payoff and the higher Sharpe ratio.

Risk comparisons

Below is the comparison between the risks of Carry Trade and Momentum as an investment strategy.

Carry trade

When money is borrowed from the bank in a certain currency (in this example currency A) and then lent out with this money in another currency (B), this is called Carry Trade. This only becomes interesting if the interest on the borrowed amount (currency A) is lower than the interest received for the loaned money. However, the risk is that the exchange rate of currency B may decrease relative to currency A. As a result, there may be a loss on the loaned money, because of which the borrowed amount cannot be fully repaid. This is called currency risk. The theoretical explanation is in the inflation differentials. In theory, the level of interest rates between two currency units will always differ if the level of inflation differs. The higher the inflation in a currency area, the higher the nominal interest rate in the same currency. After all, the currency devaluation is higher and so it is expected that there will be a higher reward for the inflation risk. The interest rate difference, i.e. the Carry, is therefore nothing more than a compensation for the inflation loss that has been incurred by investing in the other currencies. The risk is that it cannot benefit from this. This is the case when the interest rate is higher, but if a cheaper currency is returned for the loaned currency afterwards, then there is a risk of a loss. (Dommelen, 2018)

Momentum

The core of this indicator is that it indicates the speed at which the price rises or falls in a certain period. In other words, we measure the difference between today’s price and the price of a certain period before that. In formula form it looks like this:

Momentum = Course (from today) – Course (from today – n)

It is therefore logical that the momentum is high if the price of today is clearly higher than the price of 5 days ago. In contrast, the momentum is negative at the moment that the price of today is lower than the price of 5 days ago.

The line indicating the momentum then comes to lie below the zero line. Momentum investors try to profit from trend formation in the financial markets. It benefits from irrational behavior from investors. This means that the behavior can also change quickly. They invest in shares that have achieved more returns in the past period, in the expectation that they will continue to perform better. As long as the trend continues, they will indeed benefit. If the market changes sharply, however, momentum investing can also lead to losses. A disadvantage of this strategy is that it can be accompanied by a high turnover and high costs, especially if it is not applied properly. The strategy may also suffer from high outflows as investors tend to respond strongly to what is going on. This is called herd behavior (Grinblatt, 1995). When the demand falls to a certain investment, the prices will fall.

Conclusion

This is the final chapter of the literature review, where the main research question will be addressed. The main research question of this literature review is: What investment strategy between Carry Trade and Momentum is the most profitable?

The answer to this question is meant to give investors insight into which investment strategy between Carry trade and Momentum they could use for maximum value. The investment strategies have been thoroughly explained and the benefits and risks for each have been outlined. This has been done by comparing multiple research articles of the two investing strategies. The main findings will be summarised and compared in this chapter.

One of the advantages of the Carry Trade is that it imposes less of risk of losing money than with the Momentum. The whole strategy revolves around investing interest and the rate between the different currencies. The strategy is considered less risky because it is dependent on two variables while the Momentum strategy focusses on the trend of any given currency. The downside of Carry Trade can also be minimalized with forward contracts. The Momentum strategy operates by following trends of good performing stock or currencies and assuming that this trend will continue. This assumption is also made for stocks or currencies that are on a downward trend. As mentioned in previous chapters, the momentum profits are highly time varying. This could be an issue if a potential investor has to meet short term targets.

When comparing the return on investment from (Burnside et al. 2011) it shows that the Momentum strategy performs slightly better then the Carry Trade when investing in individual currencies. It also shows that Carry Trade outperforms the Momentum when it comes to investing in a portfolio of currencies. The Carry Trade has a slightly higher payoff and a significantly higher Sharpe ratio.

In the end when taking all the benefits and risks into account the findings show that the Carry Trade outperforms the Momentum and overall less risky then the Momentum. The Momentum has more time varying profits which makes it a sub optimal choice for investor with a short time horizon.

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