Thu. May 19th, 2022

Earlier this week, Bank of England researchers published a blog outlining a new study into the predictability of exchange rates. They stumbled over a simple strategy that appears to churn out results that would be the envy of any hedge fund trader.

It’s simple: buy currencies against the dollar which attract little interest in options markets, and sell those with high volumes of options trading. We’re not sure if the UK central bank will chuck in its day-to-day role to turn into a prop trading shop, but the study’s results were intriguing.

Our strategy that buys major currencies with low option volume and sells major currencies with high option volume delivers a return of more than 14% per year, with an annualized Sharpe ratio of 1.69.

The Sharpe ratio is a measure of risk-adjusted returns (using volatility as a proxy for risk), and a ratio that high surpasses most hedge funds. These folks might now be busy fielding calls from the Mayfair crowd because:

Importantly, the effect is largely unrelated to existing currency strategies and robust to controlling for interest rate differentials, currency volatility and liquidity.

Whilst casually nailing a lucrative new trading strategy the Bank of England staff also had a rare word of praise for hedge funds, who it said were the best at predicting exchange rates alongside their boring old buddies in “real money”, ie more traditional investors. (Since they actually own the money that moves markets, the guys in real money probably do not deserve the same praise.).

We find that the trading of generally better informed hedge funds and real money investors (eg asset managers, pension funds, insurers) considerably outperforms the trading of less informed clients such as corporates and non-dealer banks.

This means at least two things: those who pay 2/20 are able to say that they’ve invested in a vehicle that’s better at predicting exchange rates than your average guy on the street (though with that fee level, the gains often accrue to the hedge fund manager rathe than investors). Secondly, we now understand what “foreign exchange impact” means on corporate balance sheets.

Naturally, things are never quite this simple in financial markets, and the two-year study period (November 2014 to December 2016) is too short to bet the house on this options activity-inspired strategy. But there is a good reason for the BoE to be concerned itself about FX forecasts.

Currency markets rarely behave the way economists think they ought to. So much so that economic literature has names for the puzzles they present – including the so-called “exchange rate disconnect puzzle”, a phrase coined after the professors Richard Meese and Kenneth Rogoff found that standard models were no better at forecasting short or medium term exchange rates than a random walk.

Yet the BoE working paper – authored by staffer Robert Czech and academics Pasquale Della Corte, Shiyang Huang and Tianyu Wang – shows that FX options volumes might actually be a good indicator of future currency values, if only in the very short term.

That could give central banks a useful early warning of big currency swings that could require them to step in and help investors access dollars.

We find strong evidence that FX option volume negatively predicts future exchange rate returns, especially for the seven major currency pairs. In other words, higher option volume observed today indeed predicts a non-dollar currency depreciation (ie a US dollar appreciation) tomorrow. . . Monitoring FX option volumes would enable policymakers to anticipate periods of significant volatility in their domestic exchange rate, which could be particularly useful when trying to predict dollar demand spikes in crisis periods.

Its authors looked at data covering more than two-fifths of global trading activity in FX options over the two-year period. Inter-dealer trading accounts for more than three quarters of the total volume.

Most of it was concentrated in options on the euro, yen and sterling against the dollar, and the volume of put options, betting on an appreciation in the dollar, was almost twice as high as the volume of call options, expecting a foreign currency to appreciate against the dollar.

The researchers wanted to test the hypothesis that higher trading volumes in FX options on one day – often reflecting investors’ view of the dollar as a safe haven – would predict dollar appreciation on the next. The data bore this out.

Now, we wonder what fees structure they come up with. . .

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