This paper employs a trading strategy, previously applied only to the stock market that creates abnormal returns in the FX market. By running a simple parametric test, I find that UIP deviations follow mean reversion and momentum. In the FX market the half-life of mean reversion is very close to that obtained for the stock market, while the momentum effect is stronger than in the stock market. The combination strategy creates significant abnormal mean returns (slightly underperforming those of the stock market) and Sharpe ratios usually much higher than in the stock market. The results are also strong in comparison to strategies developed specifically for FX markets. Transaction costs do not alter the results significantly. I consider developed countries only, and the sample post January 1999 consists of just five currencies after the birth of the Euro. The portfolio I construct should be even more profitable if the currency choices are more numerous.
This paper contributes to the literature not only by applying a new strategy in the FX market, but by applying one originally designed for the stock market. The FX literature considers mean reverting behavior toward PPP values and momentum trading strategies based on moving average rules. I bring a fresh perspective to understanding FX market dynamics by considering risky asset returns, instead of macroeconomic fundamentals. This allows for the creation of a strategy based on returns (computed in this case from deviations from UIP) and a direct comparison of the exploitability of the return patterns between the FX and the stock market. Up to now strategies employed in one market have not been successfully implemented in the other market, likely due to fundamental differences between the two markets. For instance, technical trading rules were found to be completely useless in the stock market since the publication of Fama and Blume (1966), but profitable in the FX market (Sweeney, 1986; Szakmary and Mathur, 1997; and LeBaron, 1999), suggesting major differences between the markets. The striking results here, on the other hand, raise the question of why the two markets behave so similarly.
Many papers challenge the efficiency of the two markets. Neely (2002) examines the possibility that the FX market is inefficient due to Central Bank intervention. He argues that the abnormal returns obtained in the FX market through technical rules, but not existing in the stock market, are due to these interventions that have no relevance for the stock market. This paper challenges that finding. I find evidence that the FX and stock market inefficiencies have similar patterns.
One is left to wonder whether the two markets are indeed inefficient, or whether, in fact, there exists an unobserved risk factor that explains these returns. A possible theory is the overreaction hypothesis proposed from a behavioral perspective (e.g. DeBondt and Thaler, 1985, 1987) for the stock market: individuals tend to “overreact” to recent information, creating momentum. After some time, extreme movements in prices 20 will be followed by a return to fundamentals, leading to movements in the opposite direction, creating mean reversion. In foreign exchange markets, Dornbusch (1976) shows that exchange rates tend to “overshoot” in their response to monetary policies, but then revert to a long-run equilibrium. The correspondence between overreaction in the stock market and overshooting in the foreign exchange market may be responsible for the similarity in results in these two markets when the combined momentum and mean reversion strategy is applied. Examining this correspondence presents a promising direction for future research.