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Market Timing and Predictability in FX Markets

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  • Thomas A Maurer
  • Thuy-Duong Tô
  • Ngoc-Khanh Tran

Abstract

We study the economic value of market timing in foreign exchange (FX) markets, that is, using information about the conditional Sharpe ratio to adjust the notional value of a conditionally mean–variance efficient currency portfolio. Our strategy trades more (less) aggressively when the conditional risk-return trade-off is more (less) favorable. This leads to a significant improvement in the out-of-sample unconditional Sharpe ratio, skewness, and maximum drawdown per 1% expected excess return. The strategy’s market timing predicts returns, volatility, and skewness in FX markets. Popular currency pricing factors do not explain the strategy’s high average excess returns. Our findings suggest that it is costly to impose leverage or risk (i.e., conditional volatility) limits or other inferior market timing policies when constructing currency trading strategies.

Suggested Citation

  • Thomas A Maurer & Thuy-Duong Tô & Ngoc-Khanh Tran, 2023. "Market Timing and Predictability in FX Markets," Review of Finance, European Finance Association, vol. 27(1), pages 223-246.
    • Handle: RePEc:oup:revfin:v:27:y:2023:i:1:p:223-246.
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    File URL: http://hdl.handle.net/10.1093/rof/rfac014
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    References listed on IDEAS

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    1. Filippou, Ilias & Maurer, Thomas A. & Pezzo, Luca & Taylor, Mark P., 2024. "Importance of transaction costs for asset allocation in foreign exchange markets," Journal of Financial Economics, Elsevier, vol. 159(C).

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    More about this item

    Keywords

    Market timing; Leverage limits; Risk limits; FX markets; Mean–variance optimization; Exchange rates; Estimation errors;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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