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Lessons from the evolution of foreign exchange trading strategies

  • Christopher J. Neely
  • Paul A. Weller

The adaptive markets hypothesis posits that trading strategies evolve as traders adapt their behavior to changing circumstances. This paper studies the evolution of trading strategies for a hypothetical trader who chooses portfolios from foreign exchange (forex) technical rules in major and emerging markets, the carry trade, and U.S. equities. The results show that forex trading alone dramatically outperforms the S&P 500 but there is little gain to coordinating forex and equity strategies, which explains why practitioners consider these tools separately. In addition, a backtesting procedure to choose optimal portfolios does not select carry trade strategies until well into the 1990s, which helps to explain the relatively recent surge in interest in this strategy. Forex trading returns dip significantly in the 1990s but recover by the end of the decade and have greatly outperformed an equity position since 1998. Overall, trading rule returns still exist in forex markets—with substantial stability in the types of rules—though they have migrated to emerging markets to a considerable degree.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2011-021.

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Date of creation: 2011
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Handle: RePEc:fip:fedlwp:2011-021
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