An Empirical Analysis and Optimization of Carry and Momentum Strategies in the Foreign Exchange Market

Abstract

Foreign exchange is an extremely liquid and high volume market, trading an average of $5.3 trillion per day as of April 2013.\(^{1}\) Two popular strategies often employed by investors in this market are carry and momentum. The carry trade, arguably the oldest and most popular currency speculation strategy, consists of borrowing low interest rate currencies and lending high interest rate currencies. The momentum strategy consists of going long currencies that have historically yielded positive returns and going short currencies that have historically yielded negative returns. This paper backtests these strategies 15 years, staring in January 1999, using a dataset consisting of 10 currencies pairs. This paper will explore different methods of constructing carry and momentum portfolios, in order to determine which methods maximize the average annualized Sharpe ratio. Additionally, a hybrid portfolio consisting of both investment strategies will be created and optimized, to test if higher Sharpe ratios can be achieved through strategy combination. The goal of the analysis is to determine what returns are possible for an individual, U.S. investor by taking positions in a small number of liquid currencies. This paper will make recommendations for how to optimally invest in carry and momentum individually, as well as how to create a hybrid portfolio by combining both strategies.