4/2006 Andres Vesilind. The profitability of simple trading strategies exploiting the forward premium bias in foreign exchange markets and the time premium in yield curves

Working Papers of Eesti Pank. No 4, 2006

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.
JEL Code: E44, E47, E58, F37, G11, G15
Key words: trading rules, forward premium bias, time expectations theory

Author's e-mail address: vesilind [at] epbe.ee

The views expressed are those of the author and do not necessarily represent the official views of Eesti Pank.

Contents

1. Introduction
2. Theoretical overview of the structural risk premiums in the foreign exchange and fixed income markets
2.1. Forward premium bias in the foreign exchange markets
2.2. Structural time premium in interest rate markets
3. Empirical estimation of active investment models
3.1. Overview of data, methodology and investment framework
3.2. Models exploiting the forward premium bias in foreign exchange markets
3.2.1. Simple carry-based model of 10 major currencies
3.2.2. Adding risk factors to the simple carry-based FX model
3.3. Models exploiting the time premium in interest rate markets
3.3.1. Long-only positions in interest rate markets using government bond and money market futures
3.3.2. Adding filters to the long-only strategy
3.4. Combining estimated models into one portfolio
4. Conclusions
References
Appendix
Appendix 1. Calculating the value of Australian government bond futures from their price

The Profitability of Simple Trading Strategies Exploiting the Forward Premium Bias in Foreign Exchange Markets and the Time Premium in Yield Curves, Working Papers of Eesti Pank No 4, 2006 (PDF*)

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