We investigate whether the momentum effect exist in the monthly foreign exchange market using a broad basket of 62 market currencies. By forming currency portfolios on basis of past returns and employing various horizon formation and holding period, we find there are strong evidence of momentum effect. Annualized excess return of momentum strategies reach up to 9% per year. Annualized momentum excess returns decrease as the increase in formation and holding period. However, when we examine the sub period of the momentum effect, we find the momentum effect doesn’t exist continuously, especially the period which have happened some currency crisis.
We find that reversal effect exist in Sterling Crisis and European Exchange Rate Mechanism crisis around 1992, Asian financial crisis in mid-1997 and European debt crisis which starting around mid-2008. During crisis, the exchange rates may become very volatile or continuous depreciation, and some speculators take this opportunity inducing the worsen currencies situation. As a result, we have lots of negative returns in long position and positive returns in short position in our data.
Furthermore, because when the currencies become illiquid or risky, the currency dealer tend to apply wider bid-ask spread. We are wondering whether the momentum excess returns just reflect the transaction cost, so we also take the transaction cost as our consideration, finding that momentum excess returns still exist, but most of the excess returns are fairly wiped out. We conclude that the transaction cost is the important component of excess momentum returns, but not really effect the change of
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the momentum effect. Additionally, we also find that the spot rate change is dominant element on the momentum strategies, by calculating the spot rate change and applying corresponding formation and holding period of the momentum strategies.
We find higher country risk have larger and more significant momentum excess returns, comparing to the lower country risk. And similarly, when formation period become longer, the momentum effect is less significant. Additionally, we explore that the country risk have more significant impact on excess returns of momentum strategies than illiquidity risk. Since we know the illiquidity of U.S. Dollar is kind of systematic risk to the U.S. investor, the result indicate that the momentum excess returns are not significantly influenced by systematic risk. In this thesis, since we use huge currencies as our portfolio target pool, the results are more useful for large institution investor.
However, although retail investors have much less funding position, they still can use some findings in this article, and then sieve out the most suitable momentum portfolio to invest.
We have some limitation of this thesis. First, since we use 1, 3, 6, 9, 12 month as formation and holding period of our 25 momentum strategies, but each investor can have variety momentum strategy, like MOM (2,8), it may lead to different result. With a view to using the momentum strategy, we treat the one-sixth of currencies with the highest lagged return as winner currencies, and the one-sixth of currencies with the lowest lagged return as loser currencies. However, investors can have more option and use other rule to classify the winner and loser currencies. For example, investors can apply top 10 as winners and last 10 as losers. Second, the number of available currencies are very different between investors, so momentum excess return may be various. For example, Taiwanese investors may be just available for four main currencies, which is U.S. Dollar, Japanese Yen, Australian Dollar and Euro. Third, in this thesis, we calculate the return with transaction, which is bid ask spread. Because we use the spot
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and forward rate data from Datastream (Reuters), it is quoted by the U.S. institution and the momentum portfolio use the U.S. investor’s point of view. However, if Taiwanese investor want to use momentum strategies, they must be charged for higher transaction cost, since Taiwan always have wider bid-ask spread than the U.S. Consequently, the excess return of momentum strategies may become smaller than 9% per year, which is our finding. Additionally, in the thesis, we find the reversal point of currency crisis period are much shorter in the foreign exchange market. Therefore, the reversal points of the normal period are also an interesting topic.
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