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Profitability of simple trading strategies exploiting the forward premium bias in foreign exchange markets and the time premium in yield curves

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  • Andres Vesilind

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    Abstract

    This paper focuses on two actively studied inefficiencies in financial markets: the forward premium bias in foreign exchange markets (see, for example, Hansen and Hodrick 1980, Fama 1984, Bansal and Dahlquist 2000, etc.) and the empirical finding that the time expectations theory performs relatively poorly in describing the average shape of yield curves (for a list of papers see, for example, Backus et al. 1998, p 1). The goal of the article is to test whether these two inefficiencies can still offer the possibilities of earning positive and stable excess return for investors. For that purpose, first two very simple trading strategies are tested based on the abovementioned inefficiencies: buying the currencies of the countries with higher short-term interest rates against the currencies of the countries with lower short-term interest rates (i.e. simple FX carry-strategy) and holding long-only positions in longerterm interest rate futures. The results show that the two studied risk premiums are still present in the markets and enable investors to earn excess returns even with simple strategies. Additional tests show that the performance of these simple strategies can be further improved by the inclusion of a risk factor in the foreign exchange carry-strategy and by the addition of monetary policy direction and yield curve steepness filters in the long-only strategy in interest rate futures.

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    File URL: http://www.eestipank.info/pub/en/dokumendid/publikatsioonid/seeriad/uuringud/_2006/_4_2006/_wp_406.pdf
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    Bibliographic Info

    Paper provided by Bank of Estonia in its series Bank of Estonia Working Papers with number 2006-04.

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    Length: 34 pages
    Date of creation: 10 Oct 2006
    Date of revision: 12 Oct 2006
    Publication status: published
    Handle: RePEc:eea:boewps:wp2006-04

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    Keywords: trading rules; forward premium bias; time expectations theory;

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    References

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    1. David Backus & Silverio Foresi & Abon Mozumdar & Liuren Wu, 1998. "Predictable Changes in Yields and Forward Rates," NBER Working Papers 6379, National Bureau of Economic Research, Inc.
    2. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 829-53, October.
    3. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
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