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Foreign Exchange

FX investing less risky than equities, says BIS

FX trading strategies expose investors to lower downside risks than investment in equities, according to research from the Bank for International Settlements.

In its quarterly review, BIS found that from 1985 to 2011 returns on FX strategies have been larger than or on a par with those for equities. The annualised average monthly return on a foreign exchange carry trade portfolio was 7.4%, compared to 5.7% on a forex momentum strategy and 5.9% for equities, according to the research.

The study found that the risk/reward ratio for investing in FX was greater than that for equity investing, however.

The Sharpe ratios, the ratios of average excess return per unit of volatility, were higher for FX investing than for equities during the study period. That implies that while mean excess returns for FX and equities are roughly the same, FX strategies have much lower return volatility.

While Sharpe ratios suggest that FX strategies have very attractive risk/reward profiles, the BIS says they did not account for downside risks, which could be substantial.

BIS found that a single bad month can be sufficient to wipe out returns from carry trade strategies for a whole year. For FX momentum strategies, the situation was more extreme, with losses over a single month big enough to wipe out as much as two years of returns. Even so, FX strategies were less risky to the downside than equity plays, the report says.

On the plus side, BIS says that FX strategies offer investors a chance to diversify their portfolios in times of market stress.

During the financial crisis that began with the collapse of Lehman Brothers in September 2008, for example, the carry trade first saw a sharp drop followed by a quick rebound as volatility and uncertainty receded. By April 2009, initial carry trade losses were recouped, while it took the US equity market until January 2011 to recover from its losses.

“In contrast to the carry trade, momentum strategies were surprisingly successful over the crisis period,” the report says. “Thus, during this period of extreme stress FX strategies, clearly provided diversification.”

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