Handbook of Exchange Rates

16.2 Beta in the Foreign Exchange Markets

In the foreign exchange markets, it is somewhat difficult to ascertain general market returns. For one thing, at least historically, foreign exchange markets were not always thought of as an investment asset class. In addition many market participants have differing objectives. For example, central banks may trade in the market to moderate the volatility of their home currency. Companies trade FX to facilitate conducting business in foreign countries.

Hence, if we want to design a strategy which encapsulates general FX market returns, it is largely going to be confined to speculators who trade FX as if it were an investment asset class. There are several approaches we can take. We can look at indices which track the returns for currency fund managers such as the Barclay Currency Trader index. We can also construct generic systematic trading strategies, which mimic very popular strategies within FX. In this case we are thinking largely of FX carry and trend-following strategies. This is essentially our approach here in this chapter. We examine other examples such as trading the USD from a long-term directional perspective. We use the longest price histories available to conduct our analysis. We compare our generic FX carry and trend-following strategies to various benchmarks such as the S&P500 and currency fund returns.

16.2.1 Understanding the FX Carry Trade

The FX carry trade is probably the most popular strategy within foreign exchange ...