Three Typical Short-term Forex Strategies (and how they work)
Carry trade, momentum and term spread are among the most widely practised short-term multicurrency investment strategies in Forex markets.
A carry trade strategy is one in which a trader borrows in currencies with low interest rates (funding currencies) and invest the sum in those with high interest rates (target currencies). Popular funding currencies includes the US dollar, the Japanese yen and the Swiss franc. This strategy bets on the fact that if the target currency does not depreciate against the funding currency during the investment lenght, then the investor earns at least the interest differential. Note that this does not hold if the ‘uncovered interest parity’ condition holds, or when higher-yielding currencies tend to depreciate against lower-yielding ones at a rate equal to the interest differential so that expected returns are equalised in a given currency. Empirical evidence shows that this condition fails at short- and medium-term horizons and, sometimes, that currencies with high interest rates appreciate while those with low interest rates depreciate. The failure of the parity condition is well-known among traders, and this is the reason why the popularity of carry trades has wide-spreaded. The carry trade has become so commonplace that the market has created tradable benchmarks for it and has introduced structured instruments referencing these benchmarks. The carry trade puts upward pricing pressure on target currencies and downward pressure on funding currencies. This could result in amplification of underlying exchange rate moves. In addition, it may also result in more rapid exchange rate moves when carry trade investors unwind their positions.
Momentum strategies belong to the ‘trend-following’ ones. Traders buy (take a long forward position) currencies with high past excess returns (‘winners’) and sell (take a short forward position) those with low past excess returns (‘losers’). Momentum strategies may potentially perpetuate past directional moves in exchange rates. This could result in amplification as well as delayed but more abrupt exchange rate moves. These strategies draws on information from the entire cross section of tradable currencies. A trader goes long in a portfolio of winner currencies and goes short in a portfolio of loser currencies. Currency momentum therefore has a distinct cross-sectional focus, which distinguishes it from other trading strategies that also exploit short-term trends but focus on individual exchange rates. The portfolio of winners might at the same time contain both high interest rate currencies and low interest rate ones: it all depends on their short-term behaviour in the immediate past. Currencies in the short portfolio includes the Hungarian forint, the Polish zloty and the euro. One distinguishing feature of the momentum strategy is that the long-short combination requires more frequent rebalancing than the carry trade and thus results in a less stable currency composition over time. As a result, transaction costs are potentially large.
Term spread strategies are also long-short investment strategies guided by relative yield curve steepness. They represent a class of Forex investment strategies where predictive signals for exchange rates are based on the entire yield curve and can be best thought of as a refined version of the carry trade. Differentials in yield curve slopes across countries convey information about differences in term premia. This additional forward-looking information is neglected by standard carry trade traders, who only consider the short end of the yield curve when deciding which currencies to buy and sell. The simple form of term spread strategy involves going long in currencies with low term spreads (the Australian dollar and the Swedish krona are good examples) and short currencies with high term spreads (recently sterling and the Mexican peso).