Answer To: We have built spreadsheet models of foreign exchange trading strategies. The assignment for this...
Himanshu answered on Dec 23 2021
In This Report, we have covered three well established strategy namely, Carry Trade, Fair value (PPP strategy) and Cash Flow. Volatility of FX is one of the main credit risks for the private sector and must be handled successfully to secure the profitability of the business. We have briefly explained these strategies with appropriate analysis by employing historical data. Subsequently, the trading strategy criteria are adjusted for different currencies over a span of 20 years (1998 to 2018) Final Result of the study suggest that the PPP approach has higher returns on the foreign exchange market. The PPP strategy has outperformed in every circumstance with the same trading atmosphere.
The Carry Trade
FX carry trade, also recognized as currency carry trade, is a financial technique whereby a currency with a higher interest rate is used to finance trade with a low-yield currency. Using the FX carry trading approach, the dealer seeks to achieve the advantages of risk-free profit-making by utilizing the currency differential to make quick gains. The trader using this technique is attempting to grab the gap between prices, which can be significant based on the quantity of leveraging employed. Carry trade is simplest trading strategy for currency trading. For instance, Pound has a 5 percent interest rate and US Dollar has a 2 percent interest rate Trader go long on the GBP/USD, this strategy referred as carry trade. For every day trader hold that trade in the market, the broker is going to pay the difference between the interest rates of those two currencies, which would be 3 percent.
Advantages
Carry Exchange is a profitable technique as it offers both market gains and interest earnings. Carry investing allows traders to take advantage of leverage. Since a dealer pays the investor the day-to-day interest on the carry trade, the interest paid is on the leveraged sum. Example, trader open a deal for 10,000 USD and he wanted to invest only $250 as the actual margin to start the transaction, trader will be paid a daily interest of $10,000, not $250. It can build up to high annual returns.
Disadvantages
There is a reasonable degree of risk to the execution of the trading plan. The currency combinations that have the perfect circumstances to use the carry trading strategy appear to be very unpredictable. The carrying trade should be carried out with precaution as It has a high volatility. Trader does an interest-bearing favourable deal on a currency pair that pays high interest, whether the exchange rate remains the same or shifts in favour of it, the trader would be a major winner. If the trade shifts against it, the losses could be substantial. Regular payment of interest to the account will reduce the risk, but it is unlikely that it will be adequate to shield the trader from the loss of trading (CorporateFinanceInstitute, 2020)
We have collected data of Ten currencies namely, YEN, EURO, POUND, SWISSY, AUSSIE, KIWI, DANISH, SWEDISH, NORWEGIAN, CANADIAN. We have employed appropriate approaches to assess returns that show the strong success of post-crisis trading, the major losses during the crisis, and the gentler turnaround of post-crisis profitability.
Fair Value (PPP Strategy)
There are many characteristics of currency yields that make currency an appealing investment vehicle for investment firms. One of these considerations is the FX value, profoundly related to purchasing power parity (PPP), a long-term optimum exchange rate hypothesis focused on the comparative value standard of the 2 nations. Not surprisingly, various countries buy different buckets of goods; therefore, a comparable price trend may be measured. More specifically, it is feasible to figure out which nation is "lower in price" and which nation is "more luxurious" to live in. The PPP theory suggests that market disparities among countries can be narrowed over time by currency fluctuations or varying inflationary pressures. Focusing on the long-term FX market, currencies prefer to shift around their "fair value". As a result, consistently purchasing of under-priced currencies and selling of overpriced currencies contribute to a successful trading policy throughout the medium term. Lastly, the analytical community recognises the importance of measuring fair value in the foreign exchange market as one of the significant instruments as well as FX momentum.
How it works
Market experts will refer at a concept termed purchasing power parity to equate economic efficiency and quality of life among nations. PPP is a method of viewing at the comparative worth of distinct currencies when comparing markets among different nations. A price contrast could be a single product or a collection of different products.
Quantitatively, this can be interpreted as, E = Pa/Pb
Where, E refers to exchange rate among the two countries
Pa refers to price of the commodity in country A.
Pb refers to price of the commodity in country B.
On the basis of this theory, two currencies are in harmony with one another when the same commodity is valued the same in both nations, taking into consideration the comparative currency values. Let's assume, for instance, that a pair of shoes costs $100 in the US and £80 in the United Kingdom. In order to make this analogy realistic, we have to consider the currency value (exchange rates). GBP/USD currency pairs are trading at 1.30. This means that footwear in the UK cost the equal amount of $104. The PPP among the two nations, including the footwear into consideration, will be 104/100 or 1.04. This implies that if the UK customer decided to purchase the footwear at low price, they could purchase them for $4 priced lower in the US. This will convert pounds to USD, contributing to an improvement in USD compared to GBP, with everything else being equivalent.
Weaknesses in PPP strategy
Above comparison between the United States and the United Kingdom, customers in the United Kingdom may choose to save $4 a pair and only buy it in the United States. This might not be possible due to concerns such as delivery and transit prices. Trade tariffs can also force imported products to sell more costly in one country compared to another. The free movement of trade would serve to promote the legitimacy of the PPP; regulated operation would negate its importance. Time delay could also be counted as great weakness as some customer need the product immediately compared to the need to wait for an extended overseas shipment process. Imperfect markets, taxation parities and the cost of products are the most popular drawback of this technique (QuantPedia, 2020)
We have adopted investigations on the grounds of historical evidence to help explain this approach. Currencies that we have used are YEN, EURO, POUND, SWISSY, AUSSIE, KIWI, DANISH, SWEDISH, NORWEGIAN, CANADIAN, SING and HK. Below is the Price action of currency Yen, we can clearly see two variable PPP rates reverted (grey) and Spot Exchange Rate (orange) of YEN.
We have also compared PPP strategy returns with Carry trades returns, outcome can be seen below. PPP strategy gave high yields in comparison with Carry trade returns as PPP strategy has found to be more successful, as we have evaluated both the strategy on the basis of same parameters (duration)
Order Flow
Order flow trading is a method of research that includes observing the flow of trading orders and their resulting effects on markets in order to predict potential market fluctuations. Order flow analytics helps trader to see how other market players transact (buying or selling) Forex order flow is powered by the inter - bank system, which accounts for nearly half of the total amount of transactions that happen every day. Interbank sector players comprise financial and corporate banks. Since most FX market liquidity is channelled via the central bank, it is interesting to examine how these participants employ order flow knowledge to create investment choices. Order flow in the forex market is led by transactions passing via monetary companies, where counterparties vary from other selling side groups, buying side-customers, including treasuries, central banks and fund managers. Orders that sell side players receive has valuable input from consumers. The knowledge is so beneficial that some time the vendor of the side player may not charge the customer for those transactions. The secret to the use of order flow trading is to assess market scope. This explains the exchange rates at which consumers wanted to trade. Order flow is basically a collection of transactions that can occur as the price/market fluctuates. The aggressive strategy is when you see too much buy-side aggressiveness or too much sell-side aggressiveness. If this occurs, the stock will always peak out following an aggressive move (bottom). The biggest secret to an order flow disparity is to allow a high-volume spike (ForexTrainingGroup, 2020)
We have measured returns of Order flow (1998 to 2018), currencies that we have used for this analysis are YEN, EURO, POUND, SWISSY, AUSSIE, KIWI and CANADIAN. Following is the Cumulative returns of different strategies. We can clearly conclude that PPP strategy has better returns as well as strategy has performed well during the crisis in relative to other strategy.
References
CFI (2020) Carry Trade Foreign Exchange Strategy, Available at: https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/fx-carry-trade/ (Accessed: 20 Dec 2020).
Forex Training Group (2020) Fair Value (PPP strategy), Available at: https://forextraininggroup.com/understanding-order-flow-forex-market/#:~:text=Forex%20order%20flow%20is%20driven,include%20commercial%20and%20investment%20banks.&text=Most%20of%20the%20currency%20order,15%20sell%20side%20financial%20institutions. (Accessed: 20 Dec 2020).
QuantPedia (2020) Order Flow Foreign Exchange Strategy, Available at: https://quantpedia.com/strategies/currency-value-factor-ppp-strategy/#:~:text=PPP%20theory%20states%20that%20price,towards%20their%20%E2%80%9Cfair%20value%E2%80%9D (Accessed: 20 Dec 2020).
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