New strategies:
#439 – The Equity Differential Factor in Currencies
Period of rebalancing: Monthly
Markets traded: currencies
Instruments used for trading: futures, forwards, CFDs
Complexity: Simple strategy
Bactest period: 1990 – 2017
Indicative performance: 1.90%
Estimated volatility: 3.10%
Source paper:
Turkington, Yazdani: The Equity Differential Factor in Currency Markets
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3382621
Abstract:
We show that the differential in trailing equity market performance across countries strongly predicts the cross section of currency returns. Specifically, exchange rates tend to appreciate for countries that have had the strongest equity returns in the preceding year. Implementable portfolios formed on this equity differential factor generated a return-to-risk ratio superior to the traditional carry, trend, and valuation-reversion factors in currencies since 1990. The equity differential factor cannot be explained by these traditional strategies, and produces a statistically significant alpha in excess of them. Moreover, the factor has performed remarkably consistently over time, including in recent years, and it is robust to many different formulations. We conjecture that marginal investor demand for outperforming equity markets might contribute to this effect.
#440 – The Value Spread and Asset Allocation in Global Equity Markets
Period of rebalancing: Monthly
Markets traded: equities
Instruments used for trading: ETFs, stocks
Complexity: Very complex strategy
Bactest period: 1996 – 2017
Indicative performance: 5.91%
Estimated volatility: 6.37%
Source paper:
Zaremba, Umutlu: Strategies Can Be Expensive Too! The Value Spread and Asset Allocation in Global Equity Markets
https://ssrn.com/abstract=3332931
Abstract:
Is the value spread useful for forecasting returns on quantitative equity strategies for country selection? To test this, we examine a sample of 120 country-level equity strategies replicated within 72 stock markets for the years 1996–2017. The value spread is a powerful and robust predictor of strategy returns in the cross-section, subsuming other methods based on momentum, reversal, or seasonality. Going long (short) the strategies with the broadest (narrowest) value spread produces significant four-factor model alphas, markedly outperforming an equal-weighted benchmark of all of the strategies. The results are robust to many considerations.
New research papers related to existing strategies:
#25 – Small Capitalization Stocks Premium (Size Effect)
Alquist, Israel, Moskowitz: Fact, Fiction, and the Size Effect
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3177539
Abstract:
In the earliest days of empirical work in academic finance, the size effect was the first market anomaly to challenge the standard asset pricing model and prompt debates about market efficiency. The notion that small stocks have higher average returns than large stocks, even after risk-adjustment, was a pathbreaking discovery, one that for decades has been taken as an unwavering fact of financial markets. In practice, the discovery of the size effect fueled a crowd of small cap indices and active funds to a point where the investment landscape is now segmented into large and small stock universes. Despite its long and illustrious history in academia and its commonplace acceptance in practice, there is still confusion and debate about the size effect. We examine many claims about the size effect and aim to clarify some of the misunderstanding surrounding it by performing simple tests using publicly available data.
#415 – Sovereign CDS Predicts FX Market Return
Della Corte, Jeanneret, Patelli: A Credit-Based Theory of the Currency Risk Premium
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3413785
Abstract:
This paper extends the work of Kremens and Martin (2019) and uncovers a novel component for exchange rate predictability. Our theory shows that currency returns compensate investors for the expected currency depreciation in the case of a severe but rare credit event. We compute this risk compensation – the credit-implied risk premium (CRP) – by exploiting the price difference between sovereign credit default swaps denominated in different currencies. Using data for 16 Eurozone countries over the period 2010-17, we find that CRP positively forecasts the euro-dollar exchange rate return between one-week and six-month horizon, both in-sample and out-of-sample. We also show that currency trading strategies that exploit the informative content of CRP generate substantial out-of-sample economic value.
And two additional related research papers have been included into existing free strategy reviews during last 2 weeks:
#5 – FX Carry Trade
#8 – Currency Momentum Factor
#9 – Currency Value Factor – PPP Strategy
Baku, Fortes, Herve, Lezmi, Malongo, Roncalli, Xu: Factor Investing in Currency Markets: Does it Make Sense?
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3415700
Abstract:
The concept of factor investing emerged at the end of the 2000s and has completely changed the landscape of equity investing. Today, institutional investors structure their strategic asset allocation around five risk factors: size, value, low beta, momentum and quality. This approach has been extended to multi-asset portfolios and is known as the alternative risk premia model. This framework recognizes that the construction of diversified portfolios cannot only be reduced to the allocation policy between asset classes, such as stocks and bonds. Indeed, diversification is multifaceted and must also consider alternative risk factors. More recently, factor investing has gained popularity in the fixed income universe, even though the use of risk factors is an old topic for modeling the yield curve and pricing interest rate contingent claims. Factor investing is now implemented for managing portfolios of corporate bonds or emerging bonds.
In this paper, we focus on currency markets. The dynamics of foreign exchange rates are generally explained by several theoretical economic models that are commonly presented as competing approaches. In our opinion, they are more complementary and they can be the backbone of a Fama-French-Carhart risk factor model for currencies. In particular, we show that these risk factors
may explain a significant part of time-series and cross-section returns in foreign exchange markets. Therefore, this result helps us to better understand the management of forex portfolios. To illustrate this point, we provide some applications concerning basket hedging, overlay management and the construction of alpha strategies.
And one analysis of selected financial research paper we think it’s worth reading …
Siddiqi: CAPM: A Tale of Two Versions
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3350280
Abstract:
Given that categorization is the core of cognition, we argue that investors do not view firms in isolation. Rather, they view them within a framework of categories that represent prior knowledge. This involves sorting a given firm into a category and using categorization-induced inferences to form earnings and discount-rate expectations. If earnings-aspect is categorization-relevant, then earnings estimates are refined, whereas discount-rates are confounded with the category-exemplar. The opposite happens when discount-rates are categorization relevant. Earnings-focused approach such as DCF, generally used by institutional investors, leads to a version of CAPM in which the relationship between average excess return and stock beta is flat (possibly negative). Value effect and size premium (controlling for quality) arise in this version. Discount-rate focused approach such as multiples or comparables valuation, typically used by individual investors, leads to a second version in which the relationship is strongly positive with growth stocks doing better. The two-version CAPM accounts for several recent empirical findings including fundamentally different intraday vs overnight behavior, as well as behavior on macroeconomic announcement days. Momentum is expected to be an overnight phenomenon, which is consistent with empirical findings. We argue that, perhaps, our best shot at observing classical CAPM in its full glory is a laboratory experiment with subjects who have difficulty categorizing (such as in autism spectrum disorders).
