CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

35.4 FOUR MODELS FOR CURRENCY TRADING

Pojarliev and Levich (2008) describe four models for currency trading: carry, trend following, value, and volatility. Rather than assuming that all profits from currency trading are alpha, their research shows that manager skill, for currency and global macro managers, should be measured as the returns in excess of those earned from beta exposure to each of these four factors. From 1990 to 2006, Pojarliev and Levich calculated total returns to the four currency strategies combined at 62 basis points per month, with the risk-free rate accounting for 37 basis points and with 25 basis points per month remaining as the excess return of the strategies. The 25 basis points of excess return were concentrated in the years prior to 2000. In fact, after 2000, the excess return to the four strategies declined to just 8 basis points per month. The carry and trend factors were profitable, but the value and volatility strategies had returns near zero over the full time period. With a monthly standard deviation of excess returns of 3.04%, all four strategies combined had a very low information ratio. The trend and volatility return factors had the highest volatility, while the carry and value factors had much lower volatility. Their regression models of the returns of a basket of currency managers on the four strategy factors had an R-squared of 0.66, meaning that the majority of returns to currency funds were attributable to these four factors. In their ...