Hedging currency on foreign stocks was a recent topic for debate at CIR Online Debates. But there are other dimensions to currency. Not all have easy to grasp explanations.
Updating an earlier paper, “Momentum in Stock Market Returns: Implications for Risk Premia on Foreign Currencies,” Swiss National Bank researcher Thomas Nitschka finds “Momentum in foreign stock market returns is exploitable as [a] signal of currency excess returns. Past stock market winner currencies offer higher returns than past stock market loser currencies.”
The momentum effect in stocks is well known, across firms and across countries. The explanation,
“if we are willing to accept a stock market return as proxy for systematic risk, as usually done in empirical tests of the Sharpe (1964) and Lintner (1965) capital asset pricing model (CAPM),” Nitschka notes, is that “this latter finding suggests that times of high systematic risks also signal risky times in the short run. Hence, past high (low) stock market returns could indicate high (low) returns on assets other than stocks.”
That’s the theory of risk premia. In Nitschka’s own work, “past, relatively low foreign stock market returns are associated with currently low foreign currency excess returns and vice versa for the sample period from November 1983 to May 2009.”
One explanation could be that “high interest rate differentials are associated with high currency excess returns. This observation is driven by the high exposure of high interest rate currencies to systematic risks.”
But Nitschka’s work suggests otherwise. “The clear pattern in currency portfolio returns sorted with respect to stock market momentum, however, is unrelated to the respective currencies’ forward discounts.” So the performance of currencies and stocks must have another explanation.
He observes that, “time series variation in monthly stock market momentum sorted currency portfolio returns and the associated carry trade, going long in past stock market winner and short in stock market loser currencies, are partly explained by the TED spread, the spread between a risk-free T-bill rate and the LIBOR eurodollar deposit rate, a measure of liquidity or crash risk.”
So there’s one risk factor that currency trading exploits. Are there others, such as the robustness of an economy? “The cross-sectional dispersion in the foreign stock market momentum sorted currency portfolio returns under study, however, is neither explained by differences in sensitivities to macroeconomic factors such as consumption growth or changes in industrial production, though the latter variable helps to explain momentum in U.S. stock returns … nor by their exposures to the HMLFX factor [high minus low].” His conclusion: “The evidence of a ‘common’ risk factor in currency returns is hence limited.”
If currencies aren’t driven by the same risk factor, then what drives them? Is there short-term momentum? Nitschka applies a third analysis, decomposing the time series returns “into permanent components, i.e. those parts of currency returns that are driven by fundamentals, and transitory components, driven by expected returns.” But he comes up empty.
“The sensitivities of the two currency return components to HMLFX move in lockstep with average returns. High sensitivities are associated with high excess returns.” That’s what should be expected. Except, “the fundamentally driven components of stock market momentum sorted currency portfolio returns, however, are unrelated to the HMLFX factor.”
So the systematic risk premium that would explain excess returns on currency remains in the shadow regions. At least until portfolio managers start exploiting the momentum effect … effectively reducing the excess return to something more predictable?