The past two years have brought research into the area of price momentum, where past winning assets continue to perform well while past losing assets continue to perform poorly. One way to study this phenomenon is through the angle of information of an asset. Investors perceive information, namely news of the asset and of the economy, and react accordingly, leading to a momentum effect on the price.
We will develop a rigorous expression of this idea by developing a framework that divides investors into “news traders” and “momentum traders.” News traders use current and projected fundamental information about an asset and trade on it. They look at what they think is useful information, for example an announcement of lower interest rates thereby slowing down bond investments, and take positions accordingly. Momentum traders look for established trends in an asset’s price and then take positions with the belief that the trend will continue.
Information is the glue between these two groups of traders. As information diffuses into the market, price experiences underreaction as news watchers slowly adjust to the new information. It then experiences overreaction as momentum traders seek to profit from the moves that follow the under-reaction. Knowing this, a trader wants to get into the market before it has fully absorbed this new information, which by then is too late for any gains as the market has stabilized to it.
As we shall see, identifying assets whose information takes longer to diffuse into the market can be instrumental in creating a profitable strategy. But before looking into the process of information diffusion, a quick update on momentum strategies is in order.
Excess returns in foreign exchange spot can be made by adopting a momentum strategy comprising technical rules. The strategy starts by ranking currencies using a metric. The most common one advocated by momentum traders is price.
Unlike the equity market where each asset is valued in U.S. dollars, currencies are valued vs. movement against another currency, usually the U.S. dollar. This gives rise to the difficulty in capturing movement of a currency. A simple way around this is to define a basket of currency pairs that will represent a currency. The average value of the indicators applied on the individual pairs will determine the rank of this currency.
The pairs selected to represent a currency each will have their base pair as the currency represented. For example, we define the basket of pairs EUR/USD, EUR/JPY and EUR/AUD to represent the euro currency. The premise here is that a large enough basket is significant to capture the true movement of that single currency. As the euro appreciates, market forces will dictate that the majority of currency pairs whose base is the euro will appreciate too. The indicator used to rank the euro currency would then be the average of each of the three pair’s returns. We do the same for other currencies by swapping the base of the pairs with that currency, such as GBP/USD, GBP/JPY and GBP/CHF to represent the pound.
The top-ranked currencies are assumed to continually perform better and the lower ranked ones worse. Seeking to profit from this assumption, a trader buys the pair whose base is the top-ranked pair and whose quote is the lowest-ranked pair. This is the classic momentum strategy. We shall now enhance it by exploring how we can exploit the diffusion of information into the spot market.
That the foreign exchange market has an estimated average daily turnover of $4 trillion makes us appreciate the sheer wealth of information circling the currency market, which itself comprises spot and derivatives. Too much information can also be a bad thing, so we seek a portion of it that we can quantify and then capitalize on during its diffusion into spot.
The goal, then, is to choose a market, other than spot, that contains information that reflects the interactions between investors’ decisions and price action, as well as includes as many market participants as possible. Also, to move away from the bane of lagging indicators as found in most strategies, we need a market that is representative of implied movement, usually by way of its prices being dealt in the future but being agreed upon now, i.e., futures.