eThesis - Kauppakorkeakoulun sähköiset gradut

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In this thesis I study the role of style investing in foreign exchange markets and its effect on the momentum anomaly. The heterogeneous agent model of Barberis and Shleifer (2003) offers several testable propositions about a market in which investors engage in style investing. I test three of these propositions: i) asset-level and style-level momentum strategies are profitable, ii) the existence of popular styles cause individual assets to exhibit momentum, and iii) assets that belong to the same style comove more than assets in different styles.

These propositions are studied with two style pairs. The first one consists of two styles that divide currencies into high-yielding and low-yielding ones. This division resembles the two carry trade portfolios. The second style pair defines the US dollar as one style and a portfolio of the other nine studied developed currencies as the other.

Conforming to the previous findings in the literature the currency-level momentum strategies are profitable over the sample period from 1985 to 2014. The momentum strategies that measure the past returns over the preceding one and nine months exhibit the highest mean excess returns of approximately 3% p.a.

The style-level momentum strategies for both style pairs exhibit also positive returns over the sample period. The best-performing style-level momentum strategy is a three-month strategy on the US dollar style pair which returns 4.64% p.a. with a Sharpe ratio of 0.54. Excluding the one-month momentum strategies, style-level momentum for both style pairs appears at least as profitable as the currency-level momentum. Robustness checks however show that the profitability of momentum in the interest rate style pair stems largely from its exposure to the currency carry trade. The momentum of the dollar style pair is robust to the underlying strategy which suggests that the US dollar appreciates (or depreciates) in trends against other developed currencies.

Multivariate regression models on panel data show that the future one-month excess re-turns of a currency depend more on the past returns of the style to which the currency be-longs than on the past returns of the currency itself. This relation remains significant even after controlling for the level of interest rate of the currency, and provides some evidence that investors engage in style investing in foreign exchange markets which might, at least partially, cause the reported momentum anomaly.

Lastly, the examination of the correlation matrices of the excess returns of currencies and multivariate regression models provide evidence that currencies in the same style exhibit higher comovement than currencies in different styles.