Technical analysis constitutes an alternative approach to trading than that provided by arbitrage and fundamental analysis. The underlying rationale for technical analysis is that markets are human systems and that prices of instruments traded in these markets are determined to a large extent by mass psychology.
Fundamental equity analysts work alongside economists and technical analysts. They respect the methods used by economists while retaining a healthy skepticism about their forecasts. Most are duty bound to mistrust the methods used by technical analysts but, if they are honest, accord their conclusions with a degree of respect. A fundamental analyst will hesitate before putting out a report advocating a strong buy on a stock where the technical analyst says that technical indicators are strongly indicative of a likely sharp stock correction. Among the features of technical analysis are the following:
Prices move in cycles, and in cycles within cycles. Prices move in a series of “waves” and trends can be distinguished from cyclical effects. Specific price levels can be identified that act as resistance levels (for rising prices) or as support levels (for falling prices).
Identifiable patterns can be recognized in prices tracked over time and likely turning points can be identified in advance.
Specific factors that technical analysts take into account are:
The current market price versus moving averages of prices over defined time intervals, typically 30 days, 90 days, 180 days and one year.
Daily opening and closing prices and intra-day highs and lows. Charts showing these are referred to as “candlestick” charts by virtue of their appearance.
Trading volumes and whether these are rising or falling.
Technical analysis is diametrically opposed to widely accepted mainstream dogma on market efficiencies which claim that in efficient markets price changes are essentially random and that it is impossible to predict future prices from historic prices.
Technical analysis is better at explaining past price behavior than predicting future price movements (isn’t that always the way). It is easier to see price patterns with the benefit of hindsight and most forecasts are qualified in some way. A support level, for example, may be tested. If the support level is breached then technical analysis can be used to identify the next support level. If on the other hand it is tested but fails to break the support level this may lead to a new resistance level. If technical analysis provided a guaranteed way to make money then there would be more technical analysts working for their own account and less employed by brokerages and speculators.
Most financial academics studiously avoid any mention of technical analysis, treating it much as scientists would treat alchemy. A variation on Shakespeare comes from David Mamet, an American dramatist: “The poker player learns that sometimes both science and common-sense are wrong; that the bumblebee can fly; that, perhaps one should never trust an expert; that there are more things in heaven and earth than are dreamt of by those with an academic bent.”
TECHNICAL ANALYSIS
November 12, 2009 No comments »Capital Inflows and Real Exchange Rate Appreciation – practice
July 6, 2009 No comments »During much of 2000, the National Bank of Poland tightened monetary policy by hiking interest rates to squash inflation. Towards the end of that year, with the NBP’s 28-day intervention rate having peaked at around 19%, nominal and real interest rates peaked, as did inflation. The result was irresistible to fixed income investors, attracted both by extremely high interest yields and the prospect of capital gains. As the NBP began cautiously to relax its monetary policy, this triggered an increasing tide of capital inflows. Asset managers reduced or even eliminated their currency hedges. Dedicated emerging market investors raised their asset allocation in Polish bonds, while cross-over investors increased their exposure to what was an off-index investment.
Capital Inflows and Real Exchange Rate Appreciation – theory
July 5, 2009 No comments »Under a pegged exchange rate, capital flows are attracted by the perception of exchange rate stability created by the peg itself. Conversely, under freely floating exchange rates, such capital flows are attracted by the prospect of high returns, either of income or capital gain. Fundamental flows are attracted to a currency, attracted both by currency and underlying asset market-related valuation considerations. Such capital inflows force the currency to appreciate and simultaneously force nominal interest rates lower. As a result, during this period, the correlation between the asset markets and the currency increases. Capital flows lead to both nominal and real exchange rate appreciation.
MEASURING CURRENCY RISK — VAR AND BEYOND
July 4, 2009 No comments »Value at risk is defined as:
The maximum loss for a given exposure over a given time horizon with x% confidence
VaR helps a user to define the maximum loss on an exposure for a given confidence level and has helped investors and corporations in managing their risk. VaR is on the face of it an excellent risk management tool, which can be used to measure a variety of risk types.
However, it should be noted that:
VaR does not define the worst case scenario
It may give the maximum loss for an exposure with 99% confidence using a 3000-iteration Monte Carlo simulation. The question remains however, what happens to the exposure for that 1% point of confidence? The frank truth is a VaR model is incapable of answering that question. Thus, a degree of both care and common sense is needed. The more sophisticated corporate Treasuries frequently seek to refine their VaR model to go beyond the natural confidence level limit to try and define the maximum loss with 100% confidence. A practical way of trying to achieve this is to impose operational limits (such as in terms of number of contracts, nominal amount, sensitivities or stop loss orders) in addition to VaR limits. That relates to the aspect of care. The common sense aspect relates to never trusting your risk to a computer model alone. If you cannot quantify it itself without use of the model, you have a problem.
Trend-Following Strategy
July 3, 2009 No comments »A second popular strategy for active currency managers is the “trend-following” strategy, which involves using several technical moving averages to provide trading or hedging signals. Active currency managers can use this strategy to either trade around their benchmark in order to add alpha, or alternatively to provide a hedging signal. The academic backing for trend-following strategies is as deep as that for the differential forward strategy, including works by Bilson (1990, 1993), Taylor (1990), LeBaron (1991) and Levich and Thomas (1993), which showed that these strategies can indeed produce consistent excess returns over sustained periods of time. I would suggest however that the seminal breakthrough in this area came in the form of the note by Lequeux and Acar (1998), which gave the strategy more specific properties by suggesting that in order to be representative of the various durations followed by investors an equally weighted portfolio based on three moving averages of 32, 61 and 117 days would be most appropriate. Simply put, the core idea behind this strategy is to go long the currency pair when the price is above a moving average of a given length and to go short the currency pair when it is below. More specifically, if the spot exchange rate is above all three moving averages, hedge the foreign currency exposure 100%. If it is above only two out of the three moving averages, hedge one-third of the position. In all other cases, leave the position unhedged.
Differential Forward Strategy
July 2, 2009 No comments »The core idea behind this is that of “forward rate bias”, or the reality that forward rates are poor predictors of future spot exchange rates, in contrast to the theories of covered interest rate parity and unbiased forward parity. We have looked at some of the academic backing for this admission earlier in this blog, notably by Fama (1984), Kritzman (1993) and finally Bansal and Dahlquist (2000), who suggested that the negative correlation presented by Fama between future exchange rate changes and current interest rate differentials is crucially linked to changes in macroeconomic variables.
As outlined by Acar and Maitra (2000), the differential forward strategy seeks to take advantage of the apparent market inefficiencies as represented by “forward rate bias” by hedging the currency risk only when the interest rate differential is in favour of the hedger. That is to say, only when the forward points are at a discount. Conversely, the currency manager should not hedge currency risk when the forward points are at a premium and consequently the interest rate differential would reflect a cost. More specifically, when the interest rate differential pays the investor to hedge, the currency manager should have a hedge ratio of 100%. Conversely, when the interest rate differential costs the investor to hedge, the hedge ratio should be zero. Thus, if the currency manager is operating under a symmetrical benchmark, the manager would go overweight the hedge by 50% when the interest rate differential is in their favour and underweight by 50% when it represents a cost.
The results of this strategy have proved to be extremely robust and have been tested across some 91 currency pairs.
Of necessity, when the interest rate differential is favourable, the differential forward strategy will have the same returns as a full forward hedge. Equally, when the interest rate differential represents a cost, the differential forward strategy will have the same returns as an unhedged strategy. Thus, overall, the returns of the differential forward strategy will be a function of both fully hedged and fully unhedged strategies. The advantages of such a strategy are the following:
As established, it has consistently added alpha for active currency managers.
Equally, it has also reduced risk relative to benchmarks.
The strategy combines the decisiveness of a full hedge with significant flexibility when used with a symmetrical benchmark.
The expected returns of the differential forward strategy are a function both of the expected returns of the fully hedged and fully unhedged strategies.
Given that the differential forward strategy is based on exploiting the principle of “forward rate bias”, it must follow to an extent that its expected returns are also a function in turn of the extent of that forward rate bias and thus of the interest rate differential relative to the expected future interest rate differential. For any given interest rate differential, the hedging strategy will perform best when the correlation between the hedged and unhedged returns is more negative.
EXAMPLES OF ACTIVE CURRENCY MANAGEMENT STRATEGIES
July 1, 2009 No comments »There are a wide variety of active currency management strategies that are used in the market, varying at one end of the spectrum from entirely discretionary-based trading to strict rule-based strategies. Three prominent strategies that we will look at in this series of posts are closer to the latter rather than the former end of this spectrum:
Differential forward strategy
Simple trend-following strategy
Optimization of the carry trade
All three of these strategies have consistently added alpha to a portfolio if followed rigorously and interestingly have also proven to be risk reducing compared to unhedged benchmarks. Thus, they also help to boost significantly the portfolio’s Sharpe ratio. With what follows, the contributions and advice of Henrik Pedersen of the CitiFX Risk Advisory Group and Emmanuel Acar of Bank of America’s Risk Management Advisory Group are gratefully acknowledged.