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Turning the vol up on trading FX

Published in Automated Trader Magazine Issue 34 Q3 2014

When it comes to equities, it seems fairly easy to define a beta for the market. Typically, we might think of S&P500, as a good approximation for what a typical equity investor's return might be. Indeed, there are many passive investors who follow funds which directly replicate S&P500. For bonds, we can do something similar if we pick an index such as Barclays Global Aggregate bond index.

For currency markets however, there is no such obvious index which can easily represent the returns for a typical FX investor. Instead, we need to create proxies for generic versions of popular trading strategies which are commonly used in FX - such as trend, carry and value. Trend, as the name suggests, involves buying currencies which have positive momentum and selling those which have negative momentum. Carry involves buying high yielding currencies and funding those purchases through selling low yielding currencies. Essentially, investors are picking up a risk premium when they buy carry. The risk of carry trades is the drawdowns that occur during times of risk aversion.

Value based strategies tend to be very long term. They involve creating a value metric such as PPP (purchasing power parity) and using this to define whether a currency is over or undervalued. Currencies which are overvalued are sold and those which are undervalued are bought.

At the Thalesians, we have done a large amount of research on identifying what beta is in FX. We have shown that it is possible to replicate FX fund returns (such as the HFRX FX index), by using a mixture of carry and trend. This seems to suggest that it is indeed the case that as a group, FX funds do a large amount of carry and trend following based strategies, thus suggesting that these strategies can be considered as "beta" in FX.

However, once FX investors have successfully created a beta portfolio, the question is what other strategies can they look at? One possibility is to add an FX volatility strategy...

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