1. Introduction
Momentum effect already have significant evidence on stock market (Jegadeesh and Titman 1993). Stocks that do well relative to the market over the last three to twelve months tend to continue to do well for the next few months, and stocks that do poorly continue to do poorly. Momentum effect is left unexplained by the traditional pricing model, like CAPM, which we used to measure in the financial market, and have more evidence of unsystematic risk, such as credit risk(Avramov, Chordia, Jostova and Philipov 2007) and transaction cost(Korajczyk and Sadka 2004). In this paper, we are curious about whether the momentum effect exist in the foreign exchange market. With a view to knowing this, we first investigate whether the momentum strategy is profitable or not in the foreign exchange market, and try to interpret the existence of excess returns.
Foreign exchange markets have very different market condition from stock market.
Foreign exchange markets are more liquid and highly competitive, and have the largest size, so it’s hard to charge transaction cost. In addition, there are almost no short-selling constraint, so we can fully implement the momentum strategies. Some earlier researches have tried to explain the excess returns of momentum strategies. And if we attribute the change of stock price to the company’s condition, such as size or B/M ratio (Fama and French 1993) or credit risk(Avramov, Chordia, Jostova and Philipov 2007), maybe we can ascribe the change of the exchange rate to the country’s condition. Most recently, Menkhoff, Sarno et al. (2012) find some evidence from momentum strategies in one to twelve months in foreign exchange returns in 48 different currencies and provide a general research on momentum return. However, they don’t mention whether the momentum effect exist continuously or it just happen in some of periods, so we try to explain why some period have strong evidence of momentum, but some of not.
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We start by forming the momentum portfolio. That is, we long the currencies with high lagged excess returns which we regard as winners and short the currencies with lower lagged excess returns which we regard as losers as our portfolio of momentum strategy. We rank the return of currencies every period on the basis of lagged excess return and form zero investment long-short portfolio from a momentum perspective. If the portfolio has positive (negative) return, this is the evidence of momentum (reversal).
We act as a US investor’s point of view, apply up to 62 currencies to generalize our result, and consider formation and holding periods of 1, 3, 6, 9 and 12 month. As a consequence, we apply total of 25 strategies. Our sample period covers from November 1983 to October 2014. We find large and significant excess returns on momentum strategies of up to 10% per year, but not exist all the time, it strongly depend on period by period. To explain this, we examine whether the different currency market condition will affect the existence of momentum. We use UP or DOWN market, high volatility of the involved currencies, market stress and crisis to explain why some of period have strong momentum and some of they have strong reversal.
To rationalize the high excess return of momentum strategies, we examine whether currency momentum is affected by (i) spot rate change, (ii) transaction cost, (iii) country risk, and (iv) liquidity risk.
we apply the bid-ask price when we form the portfolio, since we thought the dealers usually adjust bid-ask spread while they expect that there may be a change in country’s condition. Unfortunately, we find the transaction cost seems fairly affect the momentum strategy and the large part of momentum excess return is wiped out as we take transaction cost into account. It indicate that when we practically apply momentum strategies in the foreign exchange market, dealer will charge amount of transaction cost.
Through comparing the excess return with spot rate changes, we find that most of the
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excess return of momentum strategies are dominated by the changing spot rate. It imply that the momentum excess returns are different from carry trade return, which have been studied in some empirical literature (Lustig, Roussanov and Verdelhan 2011) and believed that the returns are dominant by differential in interest rates across countries.
We also observe the relationship between country risk and the momentum excess return and find that is exist. Excess returns of momentum portfolio on high country risk are larger and more significant than the excess returns on low country risk. In order to test whether illiquidity risks or country risk will have significant impact on momentum excess return or not. We run a time-series regression and find that there is little evidence that liquidity risk help explain the momentum excess returns. We also find the positive and significant relationship between the momentum excess returns and country risk, but it’s insignificant on liquidity risk. The results indicate that, comparing to the currency’s liquidity, the level of country risk have more impact on the momentum excess returns. We may say that momentum excess returns are affected more by country risk of the involved currencies, and the influence may include the illiquidity in the involved currencies, but it hardly result from the US Dollar illiquidity.
In summary, we provide the evidence that, although momentum excess return have been proof exist in the earlier studies, it’s not continuous exist, especially when the exchange rate become volatile and continuous depreciation. Moreover, the momentum excess returns are subject to home market condition, which is condition of U.S. Dollar market here, and some idiosyncratic characteristic of involved currencies.
The rest of this paper proceeds as follows. We discuss earlier literature in Section 2.
Section 3 details our data. Section 4 describes our methodology, such as portfolio formation procedure. Section 5 illustrate our empirical result of various momentum strategies and the relationship between the excess returns of the momentum strategy and the country risk. We conclude in Section 6.