This summary gives a practitioner’s perspective on the article “The Equity Differential Factor in Currency Markets,” by David Turkington, CFA, and Alireza Yazdani, published in the Financial Analysts Journal 2Q 2020 issue.
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This summary gives a practitioner’s perspective on the article “The Equity Differential Factor in Currency Markets,” by David Turkington, CFA, and Alireza Yazdani.
What’s the Investment Issue?
Is there a link between returns from equity markets and the performance of currencies?
Currency investment strategies largely focus on carry trades, which entail buying currencies with high interest rates and selling currencies with low interest rates. Other common currency investment strategies are based on trend, a momentum play, or valuation, which relies on mean reversion.
This article demonstrates that trading currencies based on trailing stock market performance generates superior risk-adjusted returns compared with traditional currency strategies based on carry, trend, and valuation.
How Do the Authors Tackle the Issue?
The authors create a currency trading strategy, investing in currency forwards based on trailing 12-month equity index returns. They construct 45 currency pairs from the currencies of G–10 countries, using data from 1990 to 2017. The trailing relative performance of each country’s equity market in local currency is calculated on a monthly basis. They equally weight each currency pair representing a positive equity differential and then net the exposures to determine the long–short exposure to each currency.
The same pairing process is repeated for the traditional strategies of carry, trend, and value over the same period. The various strategies are then compared.
What Are the Findings?
Trailing equity market performance is found to be a strong predictor of currency returns. In particular, exchange rates tend to appreciate for countries with the strongest equity returns in the preceding year.
The 1.9% annualized return of the equity differential strategy is higher than trend (0.1%) and value (1.5%) strategies and only slightly lower than the carry strategy, which returned 2.1% over the period. Furthermore, the equity differential strategy is found to have very low correlation with these commonly used currency strategies. It is less volatile and has less downside risk than the traditional strategies. So, on a risk-adjusted basis, its performance is not only superior but also uncorrelated with these other strategies.
The turnover of the equity differential strategy is 2.3, which is higher than for carry and value strategies and similar to trend strategies, but its risk-adjusted returns are still higher, even after costs.
The propensity of investors to chase stock market returns contributes significantly, the authors believe, to the equity differential strategy. That is, when stock markets rise strongly in a country, money flows across that border from foreign investors hoping to catch further performance. Another explanation, albeit less robust, is that stock markets anticipate future economic growth, which in turn drives demand for a currency.
What Are the Implications for Investors and Investment Managers?
Despite extensive research into the behavior of currencies and equities, little prior research links these markets. So, the evidence of a strong linkage in this study could be insightful for currency trading investors and investment firms.
The equity differential strategy offers a strong and consistent prediction of future currency returns. It is easy to implement in developed markets, by pairing currencies and creating ranked currency portfolios using the performance of equity indexes. It is demonstrably distinct from the traditional carry, trend, and value factors that are commonly used by currency investors and could thus be used in combination with these traditional strategies to diversify a currency investment portfolio.