Chartists and Fundamentalists in. Emerging Currency Markets

Transcription

1 Chariss and Fundamenaliss in Emerging Currency Markes Gerben J. de Zwar Robeco Quaniaive Sraegies Coolsingel 120, Roerdam NL-3011 AG, The Neherlands Thijs D. Markwa Economeric Insiue and Erasmus Research Insiue of Managemen Laurens A. P. Swinkels Robeco Quaniaive Sraegies and Erasmus Research Insiue of Managemen Dick van Dijk Economeric Insiue Erasmus Universiy Roerdam This version: January

2 Chariss and Fundamenaliss in Emerging Currency Markes ABSTRACT The mainsream of lieraure on emerging currency markes focuses on he crisis early warning signals models. The rise of floaing exchange rae regimes in he emerging markes since he lae nineies warrans a differen sudy. For six differen floaing emerging marke currencies we provide new evidence on he economic and saisical significance of foreign exchange rae predicion by using purchasing power pariy and real ineres rae sraegies, over he period. We also documen ha echnical rading sraegies generae economically and saisically significan reurns, even afer he inclusion of he coss enailing he bid-ask spread as well as he, non-negligible, ineres rae differenial. The mos imporan conribuion of his paper is ha we find empirical evidence ha invesmen weighs based on 12 monh pas performance of fundamenalis and charis sraegies economically and saisically improve he risk-adjused performance over naive combinaions of fundamenaliss and chariss. Hence, hese resuls provide empirical evidence supporing heerogeneous agens models ha assume ha no all raders are acing he same all he ime. All hese resuls are robus over an addiional, bu shorer, sample of nine floaing emerging markes currencies. Keywords: Emerging markes, Exchange raes, Heerogeneous agens, Purchasing power pariy, Technical rading JEL-classificaion: C53, F31, G15 2

3 I. Inroducion The lieraure on exchange rae forecasing has exensively analyzed he predicive conen of wo ypes of informaion: news on macroeconomic fundamenals as used in srucural exchange rae models, and informaion from hisorical prices and/or rading volumes as used in echnical rading rules. Meese and Rogoff s (1983) finding ha srucural models could no ouperform a naïve random walk forecas a shor horizons sill sands afer 25 years of exensive research, see Chinn, Cheung and Pascual (2005) for a recen analysis. There is somewha more evidence for he usefulness of macroeconomic informaion for forecasing exchange raes a longer horizons, see Mark (1995), Kilian (2001) and Berkowiz and Giorgianni (2001). In general, he performance of echnical rading rules a shor horizons has been found o be considerably beer, see Taylor and Menkhoff (2006) for a recen survey. The predicive abiliy of srucural exchange rae models and echnical rading rules has generally been considered in isolaion. This is quie remarkable, in he sense ha surveys among foreign exchange marke paricipans invariably indicae ha hey regard boh ypes of informaion o be imporan facors for deermining fuure exchange rae movemens, see Taylor and Allen (1992), Lui and Mole (1998), Cheung and Chinn (2001), and Gehrig and Menkhoff (2004), among ohers. No surprisingly hen, mos foreign exchange professionals use some combinaion of fundamenal analysis and echnical analysis for heir own decision making, wih he relaive weigh given o echnical analysis becoming smaller as forecasing or rading horizon becomes longer. In addiion, recenly a new lieraure on heerogeneous agens models has emerged, which allow for he presence of boh chariss and fundamenaliss in he foreign exchange marke, see Chiarella, He and Hommes (2006), and De Grauwe and Grimaldi (2005, 2006). The relaive imporance of hese wo ypes of raders varies over ime as invesors are assumed o swich beween sraegies according o heir relaive pas performance. De Grauwe and Markiewicz (2006) offer an alernaive inerpreaion of hese models, in which 3

4 marke paricipans combine echnical analysis and fundamenal informaion in order o forecas fuure foreign exchange raes. In his paper we examine he empirical evidence for he relevance of echnical and fundamenal informaion in currency markes from emerging counries. Specifically, we examine he performance of fundamenal rading sraegies based on he deviaion from purchasing power pariy and he real ineres rae differenial and a moving average echnical rading rule for six emerging marke currencies over he period In addiion, a combined fundamenalischaris sraegy is considered, wih ime-varying weighs deermined by he relaive performance of he individual rading sraegies over he pas year. Our resuls can be summarized as follows. Firs, fundamenalis sraegies generae porfolios wih economically and saisically significan Sharpe raios ha are well above one. Hence, hese resuls provide ou-of-sample evidence for he resuls in McNown and Wallace (1989), who claim ha fundamenalis sraegies perform beer in four emerging markes over he period Second, echnical rading sraegies in emerging currency markes generae Sharpe raios near one. Due o he low urnover in he sraegies we invesigae, he influence of ransacion coss on our resuls is limied. Our resuls are ou-ofsample evidence for he profis in emerging currency markes described by Marin (2001) for he period Third, we documen ha his combined invesmen sraegy renders economically and saisically significan riskadjused reurns, afer accouning for ransacions coss. The dynamic combinaion sraegy significanly ouperforms he fundamenal and echnical rading sraegies, as well as a naïve equally weighed combinaion. These resuls provide empirical evidence supporing he complemenary value of echnical and fundamenal informaion as suggesed by quesionnaires as well as he implicaions of heoreical heerogeneous agens models of Chiarella e al. (2006) and De Grauwe and Grimaldi (2005, 2006). The remainder of his paper is organized as follows. In Secion II we review he relevan lieraure on emerging currency markes and he models ha we invesigae. In Secion III we describe he daa in more deail. We examine he performance of he fundamenalis and charis sraegies in Secions IV and V, 4

5 respecively. In Secion VI we hen combine he charis and fundamenalis informaion in order o empirically evaluae he relevance of he heerogeneous agens model. Finally, we conclude in Secion VII. II. Relaed lieraure In heir seminal work, Meese and Rogoff (1983) concluded ha here is hardly any empirical evidence ha macro economic models can be used o bea predicions from a random walk model. Cheung, Chinn, and Pascual (2005) repea and exend heir analysis and indicae ha he original conclusion from Meese and Rogoff (1983) sill holds ou-of-sample. Moreover, hey conclude ha old-fashioned srucural models, such as purchasing power pariy and real ineres rae differenials (see, e.g., Frankel 1979) perform a leas as good as more recen models for five developed markes versus he U.S. over he period 1973 o Their conclusion moivaes our use of hese old fashioned srucural models in our empirical analysis. Mos of he research claiming ha srucural models perform poorly is based on developed currency markes ha experienced relaively similar inflaionary paerns. Conclusions migh be differen for currency markes wih differen characerisics. For example, McNown and Wallace (1989) find empirical evidence in favor of PPP in four emerging counries wih high inflaion raes over he period 1972 o This finding is corroboraed by Salehizaeh and Taylor (1999), who invesigae PPP for 27 emerging markes over he period 1975 o In our sudy we do no focus on formal saisical esing of coinegraion relaionships as boh previous sudies did, bu focus on he economic value of predicabiliy using he PPP relaionship and real ineres rae sraegies as in, e.g., Hazuka and Hubers (1994). Our approach is consisen wih Leich and Tanner (1991), who indicae ha he evaluaion of forecasing performance by saisical and economic measures can be differen and ha for sudies on he behavior of agens an economic crierion is ofen more relevan. Several papers documen ha professional currency raders do no only look a fundamenal currency values, bu also pu weigh on shor-erm price movemens and rading volume; see Taylor and Allen (1992), Menkhoff (1997), 5

6 Lui and Mole (1998), and Cheung and Chinn (2001) for survey sudies among foreign exchange raders based in he U.K., Germany, Hong Kong, and he U.S. respecively. This survey research leads us o believe ha echnical rading sraegies should be able o generae profis for some currencies for some ime horizons. Sweeny (1986) finds empirical evidence supporing he profiabiliy of echnical rading rules in six foreign exchange markes over he period Since hen, a large body of lieraure emerged on echnical currency rading; see, e.g. Levich and Thomas (1993) and Neely and Weller (1999). However, Olson (2004) indicaes ha profis from echnical rading in developed currency markes have declined over ime. Currenly, we know relaively lile abou echnical rading rules for emerging currency markes. Excepions are Marin (2001) and Lee, Gleason, and Mahur (2001), who invesigae simple echnical rading sraegies on spo exchange raes of emerging markes. Marin (2001) invesigaes moving average rading rules for 12 emerging markes over he period , while Lee e al. (2001) examine he profiabiliy of moving average and channel rules in 13 Lain American counries over he period Boh papers conclude ha for several currencies echnical rading is profiable, also for ou-of-sample periods, afer inclusion of ransacions coss. In his paper, we would like o exend his research and invesigae wheher moving average rading rules have been profiable in emerging currency markes over he pas decade. Conrary o he previously menioned sudies, he currencies we invesigae are freely floaing. Hence, here mus be a differen explanaion han ha cenral bank inervenions are he driving force behind he profiabiliy of echnical rading sraegies as suggesed by, e.g., Czakmary and Mahur (1997). Frankel and Froo (1990) provide empirical evidence for he swich of many professional forecasers from fundamenalis (using srucural models and macro daa) o charis (using echnical rading rules). They moivae his changing behavior because fundamenaliss experienced negaive reurns in he mid-80 s, when currency prices deviaed from heir fundamenal values. These conceps have hereafer been formalized in so-called heerogeneous agens models. Brock and Hommes (1997, 1998) developed equilibrium models in which agens updae heir beliefs abou he profiabiliy of invesmen sraegies on pas 6

7 performance. These heoreical models show ha raional invesors can swich beween simple (cosless) sraegies and sophisicaed (cosly) sraegies. When all invesors follow he simple sraegy prices may diverge from heir fundamenal value, making i worhwhile for invesors o engage in sophisicaed sraegies, because expeced profis increase. Prices are hen pushed back o heir fundamenal value and he expeced ne profis for sophisicaed invesors are negaive, which forces hem o swich back o simple and cosless sraegies ha migh again lead o prices ha move away from heir fundamenal value. De Grauwe and Grimaldi (2005, 2006) have applied hese heerogeneous agens models o currency markes and have shown ha several previously puzzling characerisics of foreign exchange reurns can be generaed by hese ype of models using simulaion analysis. Basically, heerogeneous agens models assume ha he fundamenal value (which can be based on for example PPP) of he exchange rae is a random walk: * * (1) S = S 1 + ε where * S is he fundamenal exchange rae a ime and ε a sochasic innovaion based on new informaion ha became available during period. The fundamenaliss basically assume ha he acual exchange rae will rever owards is fundamenal value. The expeced change in he exchange rae according o hese fundamenaliss is hen * (2) E { S + } = θ ( S S ) f, 1 f wih θ f < 0 he speed of adjusmen o he fundamenal value, and S he acual exchange rae a ime. Chariss, on he oher hand, are assumed o ignore he fundamenal value of he currency and only focus on pas price movemens in he currency and exrapolae hese in heir expecaions: E K, S + = θ k = 0 α k (3) c { 1} c k S wih α he weighs o he price a ime k and θ > 0 he degree of k c exrapolaion ha he chariss use. Based on he realized profis of boh fundamenaliss and chariss, hey decide o eiher sick wih heir sraegy or swich o he oher sraegy. The number of agens following he fundamenalis and charis sraegy can hen for example be denoed as 7

8 (4) N N f, c, = exp = exp K exp{ γ φ π } k = 1 f, k f, k K K { γ φ π c k } { f k } k = c k, + exp γ φ π 1, k = 1 f, k, K exp{ γ φ π f k } k = 1 c, k, K K { γ φ π c, k } + exp{ γ φ π f, k } k = 1 c, k k = 1 f, k where γ is a parameer ha denoes he swiching inensiy, π he profis in period, and φ k he weigh assigned by agens o profis in period -k. From Equaion (4) i follows ha he number of chariss N c increases when profis on he echnical rading sraegy have been higher in he pas. This is in line wih he survey evidence from Frankel and Froo (1990) as discussed before. This line of lieraure has generally been lacking empirical analyses o validae he predicions made by hese heerogeneous agens models. Several aemps, e.g. Vigfusson (1997), Ahrens and Reiz (2005), and De Jong, Verschoor, and Zwinkels (2006) find only limied evidence in favor of hese heerogeneous agens models. Vigfusson (1997) uses a Markov-swiching approach o esimae he changing number of fundamenaliss and chariss for he U.S. Canada daily exchange rae over he period Ahrens and Reiz (2005) build on he work of Vigfusson (1997) and find empirical evidence of he charis and fundamenalis model using a regime swiching approach on he U.S. German daily exchange rae over he period De Jong e al. (2006) find evidence of he presence of fundamenaliss and chariss in a sample of European currencies from , bu fail o find significan swiching behavior beween hese groups measured by he swiching inensiy. Our sudy aims o exend his empirical lieraure on heerogeneous agens and shed more ligh on he ineracion beween chariss and fundamenaliss in emerging currency markes. 8

9 Given he plehora of currency crises 1 ha plagued he emerging markes, mos sudies on emerging markes currencies focus on early warning sysem models ha predic financial crisis. Early research was conduced by he Inernaional Moneary Fund (IMF) and resuled in wo seminal papers by Kaminsky e al. (1998) and Berg and Paillo (1999). These wo sudies predic currency crisis wih he help of a signal approach based on macro economic variables. Laer on logi and probi models were used o esimae he probabiliy of a crisis. We refer o Kaminsky (2006) for a recen overview of he early warning sysem models lieraure. Lae eighies many emerging marke counries pegged heir currency o he US dollar or a baske of developed currencies o achieve price sabiliy afer a period of (hyper) inflaion. Some counries used a crawling peg, where he currency was allowed o depreciae a a seady rae such ha he local inflaion rae could be higher han he pegged counry s rae. Lae nineies, a side effec of all he emerging markes currency crises in he pas decade is ha mos emerging markes changed heir exchange rae sysem from a pegged o a floaing regime. If we limi ourselves o he open emerging marke counries, represened by he S&P/IFC composie invesable index, only wo counries sill have a (crawling) peg regime (China and Malaysia). All oher counries have he (managed) floaing currency sysem, as becomes clear in Figure 1. This figure shows he relaive number of counries per currency regime of he S&P/IFC invesable index 2, where four differen regimes are idenified: peg, crawling peg, managed floa and floa. 1 Since 1990 several severe crises ook place in he emerging markes. During he Tequila crisis in 1994, he Mexcian Peso was aacked, devaluaed and changed o a floaing currency. Laer on aacks on oher Lain American counries occurred in Argenina, Brazil, Peru and Venuzuela. The Asian crisis sared in July 1997 wih a floaaion of he Thai bah. Aacks on oher emerging marke counries occurred afer ha in Malaysia, he Phillipines, Indonesia, Hong Kong, Korea and even on Brazil and Chile. More recenly he crises in Turkey in 2001 and Argenina in 2001 did no affec oher counries. We refer o Kaminsky (2006) for a more deailed overview of currency crisis. 2 The S&P/IFC Invesable Composie Index consiss of socks from he following counries, wih he firs monh of inclusion in parenhesis. In case wo monhs are provided, he second indicaes he las monh of inclusion. Lain America: Argenina (Dec 1988), Brazil (Dec 1988), Chile (Dec 1988), Colombia (Feb Nov 2001), Mexico (Dec 1988), Peru (Jan 1994), Venezuela (Jan Nov 2001); Asia: China (Oc 1995), India (Nov 1992), Indonesia (Sep 1990), Korea (Jan 1992), Malaysia (Dec 1988), Pakisan (Mar Nov 2001), Philippines (Dec 1988), Sri Lanka (Jan Nov 9

10 Figure 1: Exchange rae regime classificaion S&P/IFC invesable counries 100% Relaive number of counries per currency regime of he S&P/IFC invesable index 80% 60% 40% 20% 0% dec-88 dec-89 dec-90 dec-91 dec-92 dec-93 dec-94 dec-95 dec-96 dec-97 dec-98 dec-99 dec-00 dec-01 dec-02 dec-03 dec-04 dec-05 Relaive number of counries Pegged Crawling peg Managed floaing Floaing All counries in he S&P/IFC composie invesable index are classified in four differen currency regimes. The classificaion is based on Calvo and Reinhar (2001) and IMF informaion. Under a pegged regime he exchange rae is pegged a a fixed of anoher counry s currency. Under a crawling peg he exchange rae is fixed bu also allowed o seadily depreciae. Under a managed floa he exchange rae floas wihin relaively wide bands and he currency is pracically floaing. Under a floaing regime he exchange rae is se by demand and supply. When price sabiliy is under conrol he advanages of a floaing regime are enormous: he exchange rae movemens will be smaller, more gradual and less non-linear han under a pegged regime. The daily flucuaions make clear o all marke paricipans how much risk is involved and a depreciaion of he exchange rae may provide an early warning signal o he cenral bank and oher policy makers. A his momen he large number of floaing regimes warrans a differen sudy o he emerging marke currencies han he early warning signals sudies, alhough a currency crisis can no be ruled ou in he fuure. III. Daa descripion 2001), Taiwan (Jan 1991), Thailand (Dec 1988); Europe: Czech Republic (Jan 1996), Greece (Dec 1988 Apr 2001), Hungary (Apr 1994), Poland (Apr 1994), Porugal (Dec Mar 1999), Russia (Nov 1997), Slovakia (Nov Nov 2001), Turkey (Aug 1989); Africa & Middle Eas: Egyp (Nov 1997), Israel (Dec 1996), Jordan (Dec Nov 2001), Morocco (Nov 1997), Souh Africa (Apr 1995), and Zimbabwe (Apr 1994 Nov 2001). Currency regime daa is no available for Jordan and Zimbabwe. 10

11 We examine he exchange raes of six emerging marke currencies versus he US dollar: he Mexican peso and Peruvian sol from Lain-America, he New Taiwanese dollar and he Indian rupee from Asia, and he Souh African rand and he Israeli shekel from Europe, Middle-Eas, and Africa (EMEA). The reason o use hese specific currencies is ha hey have he longes hisory of being floaing, alhough he cenral banks someimes inervene o dampen volailiy. 3 Furhermore, we wan o include wo currencies from each emerging marke region o avoid any regional bias in our resuls. We employ boh daily and monhly raes, for he echnical rading rules and he fundamenal models, respecively. The exchange raes correspond o Reuers 07:00 middle rae fixings, colleced and provided by Robeco. The sample period runs from March 31 s 1995 o March 31 s 2006 (2871 daily and 133 monhly observaions). In Secion VI, we consider an addiional nine emerging marke exchange raes wih a shorer hisory of a floaing regime. We feel ha our analysis is mos relevan for he free floaing exchange rae regimes as prices in hese sysems are purely se by supply and demand. Daa before 1995 is hus no considered, as mos of he counries in our sample adoped a floaing exchange rae sysem around ha ime or jus before. The Mexican peso was allowed o floa in December 1994, causing he Peso crisis wih a depreciaion from abou 4 o 11 peso per dollar 4. The Israeli shekel was inroduced in In 1986 he link wih he US dollar was broken, bu he shekel was subsequenly linked o a baske of major currencies. The band in which he shekel was allowed o flucuae was widened each year. Since 1995 he shekel is pracically floaing, while he Bank of Israel has no inervened since June The oher currencies became floaing earlier in respecively 1989 (Taiwan dollar and Souh African rand), 1990 (Peruvian sol 6 ) and 1993 (Indian rupee). All currencies are radable in he forward marke, alhough he 3 Cenral bank inervenion has been considered as one of he possible explanaions for he profiabiliy of echnical analysis, see LeBaron (1999) and Neely (1998, 2002). We do no explore his furher in his paper. 4 Sidaoui (2005) discusses he Banco de Mexico floaing regime experience in more deail. 5 Sokoler (2005) discusses he Bank of Israel inervenion in more deail. 6 Armas (2005) discusses he Cenral Bank of Peru inervenions and is moivaions for he period

12 Peruvian sol, Taiwan dollar and Indian rupee are raded as non-deliverable forwards. This means ha he profi or loss on he forward conrac is seled in US dollars insead of he emerging currency. The invesmen reurn on a currency is defined as: (5) r = s f 1, T, where s is he log spo rae a ime and and f,t is he log forward rae a ime on a conrac mauring a ime T. In he absence of arbirage opporuniies, he forward rae is given by: EM US (6) F = S exp( i i ) where i EM, T, and i US are he risk free ineres rae in he emerging counry and he US, respecively. Subsiuion of (6) in (5) leads o he reurn on a foreign exchange invesmen: (7) US EM r s s 1 + i 1 i 1 =. Many sudies on rading sraegies for developed exchange rae markes disregard he ineres rae differenial as he influence on profiabiliy is found o be negligible see Sweeney (1986) and LeBaron (1999), among ohers. For emerging markes he ineres rae differenials can be subsanial, as shown below, and herefore should be aken ino accoun. The ineres raes are aken from wo differen sources: Bloomberg and he IMF Inernaional Financial Saisics (IFS) daabase. The monhly IFS daa has he advanage ha i is available for a longer period while he Bloomberg daa is daily updaed. As daily daa enails more informaion, Bloomberg 3 monh inerbank ineres raes are used from he momen hey are available; oherwise he IFS hree monh deposi raes are used. 7 Daa on inflaion (based on he Consumer Price Index (CPI)) also is aken from he IFS daabase and is four monhs delayed o avoid any look-ahead bias in our analysis due o publicaion lags in he CPI daa. 7 The daily daa are available as of March 1995 (Peru), Ocober 1995 (Souh Africa), November 1995 (India), November 1996 (Israel), November 1999 (Mexico) and November 2005 (Taiwan). 12

13 Sample saisics for he monhly reurns of he six emerging foreign exchange markes are repored in Table 1. Table 1 : Summary saisics Mexico Peru Taiwan India S-Africa Israel Mean Sandard deviaion Skew Kurosis Jarque-Bera Mean spo rae reurn Mean IRD Noe: The able shows annualized saisics of monhly reurns on six emerging markes foreign exchange raes (based on a long US dollar posiion and a shor posiion in he emerging marke) for he period March March The reurns include he spo rae change as well as he ineres rae differenial beween he US and he specific emerging marke counry. Rows 7-8 repor respecively he average reurn on he foreign exchange rae only and he average ineres rae differenial. The Mexican peso has he bes performance wih an annualized mean reurn of - 9.2% per year, meaning ha a long Mexican peso posiion and a shor US dollar posiion resuled in a yearly profi of 9.2 percen on average. Noe ha he Mexican peso acually depreciaed wih 5.1 percen per year over he sample period, bu his depreciaion is more han compensaed by he ineres rae differenial of percen. The Taiwanese dollar has he wors performance wih an average reurn of -2.2 percen per year. The annualized sandard deviaions of reurns range beween a low of 4.2 percen for he Peruvian sol and a high of 15.5 percen for he Souh African rand. Kurosis is much higher han hree, indicaing a high peak and fa ails in he empirical disribuion of he reurns relaive o a normal disribuion. The ail behavior of emerging marke currencies is sudied in deail by Candelon and Sraemans (2006). The Jarque- Bera es shows ha none of he currency reurns are Gaussian which is due o he high kurosis and he nonzero skewness. From he las wo lines we conclude ha we canno disregard he ineres rae differenial in our reurn calculaions. The average ineres rae differenial is even larger han he spo rae reurn for four ou six markes. The (unrepored) descripive saisics for he daily daa show a similar paern, alhough he kurosis is higher. Table 2 shows he correlaions of he monhly reurns. All correlaions are close o zero and only five ou of he 15 correlaions are significan. These small correlaions are advanageous for our sudy, as i means ha he models have o cover differen ypes of markes. 13

14 Table 2 : Correlaion marix of monhly emerging markes exchange rae reurns, March 1995-March 2006 Peru Taiwan India S-Africa Israel Mexico 0.30* * Peru * Taiwan 0.25* 0.22* India S-Africa 0.10 Noe: An aserisk indicaes significan a a 5% level. Transacion cos esimaes, defined as he bid-offer spread, for our emerging currencies are aken from 2001, he middle year of our sample, and vary per currency. We use he JP Morgan Guide o Emerging Marke Currency Opions (2001) as a source and are shown in Table 3. Table 3 : Transacion cos esimaes Mexico Peru Taiwan India S. Africa Israel Bid Offer B/O spread (BP) Average daily volume Noe: The able shows he bid and offer price in USD, and he B/O spread in basis poins as of The average daily volume is esimaed by JP Morgan (2001) and is in billions of USD per day. Transacion coss are highes for India and Peru, which can be explained by he fac ha hese foreign exchange markes are less developed han he oher counries. They are also less liquid, as shown by he average daily volumes. Transacion coss will only be considered for he sraegies ha allow rading on a daily basis. IV. Fundamenalis rading sraegies Fundamenaliss believe ha news in economic fundamenals is responsible for exchange raes movemens. A fundamenalis akes ino accoun all fundamenal variables ha are deemed o be imporan for deermining he exchange rae. In his sudy he available informaion for he fundamenaliss is approximaed by he deviaion from he PPP exchange rae and he real ineres rae differenial. In is simples form PPP saes ha he nominal exchange rae is deermined by he relaive price levels of he wo counries involved, as idenical goods should have he same price when expressed in he same currency. Taylor and Taylor 14

15 (2004) provide a recen comprehensive overview of he PPP lieraure. We obain he PPP exchange rae PPP S using he recursive relaionship 1+ π PPP PPP (8) S = S 1 US 1+ π EM 1, 1, wih S PPP 0 = S0, where π EM 1, and π are he monhly consumer price inflaion raes in he US 1, emerging marke and he US, respecively. Noe ha we assume ha PPP holds a he sar of he sample period ( S PPP 0 = S0 ). In addiion, for Taiwan we rebalance hree monhs afer he Asian crisis, based on he assumpion ha he reason for a currency crisis is o regain equilibrium. This is in accordance wih he Peso crisis, because around he sar of our sample, March 1995, he Peso crisis is said o be ended. The PPP-based rading sraegy boils down o aking a long posiion in he emerging marke currency when he acual spo rae is below he PPP-rae and a shor posiion when i is above. We denoe his forecasing rule or signal as (9) PPP PPP = 1 if S PPP > S = 1 oherwise Monhly series of signals were consruced using he monhly CPI. The ineres raes differenial sraegy uses he ineres differenial o generae buy and sell signals. Given he high inflaion in emerging markes we do no consider he nominal differenial bu a he real ineres differenial (RID), see Isaac and De Mel (2001) for a recen discussion of he real ineres raes differenial lieraure. The RID forecasing rule is defined as: (10) RID RID US US EM = 1 if i π > i π = 1 oherwise EM Tha is, we ake a long (shor) posiion in he emerging marke currency if is real ineres rae is above (below) he US one. We assume ha our fundamenalis invesor combines he signals given by PPP and RID for making her ulimae decision. Of course, here are infiniely many ways o combine he wo pieces of informaion. Here we simply ake he average of he wo signals, ha is 15

16 (11) Fundamenalis PPP + RID = 2 The combined fundamenalis signal will be +1 if boh PPP and he real ineres rae differenial are negaive on he emerging marke currency. The signal will be neural if he signals are he opposie of each oher and he signal will be -1 if boh signals are posiive on he emerging marke currency. Given he definiion of boh indicaors oher signals are no possible. The fundamenalis signal is used o implemen a rading sraegy. The reurn of he sraegy, sra r,, is compued as r, Fundamenalis r + 1. In addiion, we sra i i = consider sraegies based on he individual PPP and RID signals. The Sharpe Raio is used as he main crierion o judge he performance of he sraegies. The sraegies are implemened for each of he six currencies individually. In addiion, we consider he performance of equal-weighed (EW) and volailiyweighed (VW) porfolios. The weighs in he laer porfolio are based on he ex pos volailiy of he spo raes, based on he idea behind ha each currency conribues an approximaely equal amoun o he oal porfolio risk. The reurn of he equal-weighed porfolio is compued as EW 1 (12) = r 6 sra r, i i Ω where Ω is he se of currencies used in his sudy. The reurn of he volailiyweighed porfolio is compued as VW 1 r, i (13) r = 1 i σ Ω i σ i Ω i sra where σ i is he volailiy of he spo rae for counry i. The resuls are summarized in Table 4. 16

17 Table 4 : Invesmen reurns o fundamenal rading sraegies, Mexico Peru Taiwan India S.Africa Israel EW VW Reurn PPP RID Fundamenal Volailiy PPP RID Fundamenal Sharpe PPP RID Fundamenal saisic PPP RID Fundamenal Noe: The able shows mean and sandard deviaion of reurns, in annualized percenage poins, for fundamenal sraegies applied o emerging markes exchange raes over he period PPP is he purchasing power pariy sraegy, RID is he real ineres rae differenial sraegy and Fundamenal denoes he combined PPP and RID sraegy. Columns 2-7 repor he saisics for he individual currencies. Columns 8-9 repor respecively he equal-weighed and volailiyweighed porfolio saisics. Transacion coss are no aken ino accoun. Several ineresing conclusions emerge. Firs, he performance of he sraegies for individual currencies based on PPP or RID only are fragile. Alhough all average reurns for hese sraegies are posiive, hey only are significan (a a 5% level) for one or wo currencies. In addiion, he performance of he PPP and RID sraegies may differ considerably, see e.g. Israel and India. Second, combining he PPP and RID signals pays off in erms of sabilizing he reurn and reducing risk. For mos currencies he volailiy of he fundamenal sraegy is subsanially lower han he volailiies of he PPP and RID sraegies for all currencies, see Mexico in paricular. The performance of he combined fundamenal model is significan for four of he six markes a he 5% level, wih Souh-Africa and Israel being he excepions. Third, combining currencies in a porfolio is an even more effecive means for improving he sraegies performance hrough risk reducion. This holds in paricular for he volailiyweighed porfolio, where he sandard deviaion of he reurns on he combined sraegy is only 2.1 percen. The imporance of volailiy weighing is also suggesed by he subsanial differences in he volailiy of reurns across he individual currencies. A he aggregaed volailiy-weighed porfolio level we observe ha boh he PPP and RID sraegy have a similar performance wih 17

18 Sharpe Raios close o 1. Combining he wo signals sill enhances he performance, wih he Sharpe Raio increasing o V. Charis rading sraegies Among he differen ypes of echnical rading rules employed by chariss moving average rules are one of he mos popular ypes. Moving average rules generae a long signal when a shor moving average of K days is above a longerm moving average of L days, ha is (14) Charis Charis = 1 if K 1 K k = 1 S k = 1 oherwise L 1 L l= 1 S l where K < L. Moving average rules are someimes referred o as rend-following rules, as hey generae long (shor) signals when he exchange rae has recenly been rising (falling). In order o preven daa-snooping, as discussed in he conex of echnical rading rules by Sullivan, Timmermann and Whie (1999), we decide o only es one paricular rule wih K=20 and L=65, corresponding o one and hree monhs, respecively. This ype of charis sraegy fis well wih he moving average rules ha are ofen assumed in heerogeneous agens models, see Chiarella e al. (2006). We compue he reurns of he moving average sraegy as before, wih he difference ha he signal in (14) is updaed daily. Given ha his may lead o high urnover, we now also consider he effecs of ransacions coss. Table 5 conains he empirical resuls from he moving average sraegy based on Equaion (14) for he six emerging markes in our sample. We observe ha he average reurns of hese sraegies are posiive for all six currencies, and significan a he 5% level for four exchange raes. 18

19 Table 5 : Invesmen reurns o echnical rading sraegy, Mexico Peru Taiwan India S.Africa Israel EW VW Reurn Volailiy Sharpe Raio saisic Noe: The able shows mean and sandard deviaion of reurns, in annualized percenage poins, for he moving average sraegy applied o emerging markes exchange raes over he period Columns 2-7 repor he saisics for he individual currencies. Columns 8-9 repor respecively he equal-weighed and volailiy-weighed porfolio saisics. Transacion coss are no aken ino accoun. The bes risk-adjused resuls are obained for he Taiwan dollar, wih a Sharpe raio of 1.23 and -saisic of This is in line wih Lee, Pan, and Liu (2001), who find ha moving average echnical rading rules work well for he Taiwan dollar over he period The Mexican peso has an average reurn of almos zero, which is in conras wih he posiive resuls repored by Lee, Gleason, and Mahur (2001) for he period Apar from he differen sample period, his discrepancy can also be explained by he fac ha Lee e al. (2001) do no ake ino accoun he ineres rae differenial in he calculaion of he reurns. As we have seen in Table 1. he ineres rae differenial is no negligible for he Mexican peso. Combining he individual currencies again achieves a large reducion in risk. The equal-weighed porfolio based on he moving average rading rule has a highly economically and saisically significan Sharpe raio of The Sharpe raio furher increases o 1.10 for he volailiy-weighed porfolio, as he moving average rule performs wors for he highly volaile Mexican peso and Souh- African rand on an individual basis. The resuls including ransacions coss are displayed in Table 6. As he moving average rule esed in his research is raher slow, urnover is relaively low, and hence ransacions coss only play a minor role. The number of changes in posiion ranges beween 6 and 8 per year, which means ha he charis rades abou once every wo monhs. The porfolio Sharpe raios decline from 1.05 o 0.92 for equal-weighing and 1.10 o 0.91 for volailiy-weighing, respecively. The saisical significance remains. 19

20 Table 6: Invesmen reurns o echnical rading sraegies , including ransacions coss. Mexico Peru Taiwan India S.Africa Israel EW VW Reurn Volailiy Sharpe Raio saisic Turnover Noe: The able shows mean and sandard deviaion of reurns, in annualized percenage poins, for he moving average sraegy applied o emerging markes exchange raes over he period Columns 2-7 repor he saisics for he individual currencies. Columns 8-9 repor respecively he equal-weighed and volailiy-weighed porfolio saisics. Transacion coss are aken ino accoun and aken from Table 3. The porfolio urnover is defined as he average number of sign changes per year. Thus, based on our empirical analyses, we conclude ha chariss may benefi from applying echnical rading rules in emerging markes currencies. VI. Heerogeneous agens sraegies In he previous wo secions we analyzed he profiabiliy of fundamenalis and charis invesmen sraegies for emerging currency markes. The empirical resuls indicae ha boh ypes of sraegies generaed on average significanly posiive resuls over he period In his secion, we invesigae wheher i is worhwhile o combine fundamenal and echnical analysis, wih he weigh given o he wo ypes of signals depends on heir relaive pas performance. As discussed before, his empirical quesion relaes o he heoreical research on heerogeneous agens models of Chiarella e al. (2006), De Grauwe and Grimaldi (2005, 2006) and De Grauwe and Markiewicz (2006), in which agens may swich invesmen sraegies based on pas performance. Basically, wha we ry o do is empirically validae Equaion (4). Previous empirical research on heerogeneous agens models, such as Vigfusson (1997) and De Jong e al. (2006), found only limied evidence supporing he swiching behavior ha follows from he heoreical models. Our sudy conribues o his line of lieraure by examining he profiabiliy of sraegies ha swich beween fundamenalis and charis sraegies based on pas performance in emerging currency markes. 20

21 Figure 2: Scaer plos of monhly reurns on he fundamenalis and charis sraegies Mexico Peru fundamenalis fundamenalis charis charis Taiwan India fundamenalis fundamenalis charis charis Souh-Africa Israel fundamenalis fundamenalis charis charis Before urning o he combined invesmen sraegies in deail, heir poenial benefis are illusraed by means of he scaer plos of monhly reurns on he fundamenalis and charis sraegy for each of he counries, as shown in Figure 2. For observaions in quadrans I and III, boh sraegies generae posiive and negaive reurns, respecively. Combining he sraegies for hese monhs is no worhwhile. The percenage of observaions in hese quadrans ranges beween 25 percen for Mexico o 56 percen for India, see Table 7. Conversely, his means ha beween 44 and 75 percen of he observaions are in quadrans II and IV, represening monhs in which one ype of invesor incurs a loss while he oher incurs a gain. This suggess ha he invesor could benefi from swiching 21

22 beween fundamenalis and charis invesmen sraegies or combining he wo sraegies. Table 7 : Conemporaneous reurns of charis and fundamenal sraegies Quadran Mexico Peru Taiwan India S.Africa Israel I II III IV Axis Noe: The numbers in rows 2-5 denoe he percenage of he oal observaions ha are in a cerain quadran and no on an axis. The row labeled Axis indicaes he number of observaions ha are on an axis (because he fundamenal signal can be zero). The mos crucial decision o make when combining he fundamenal and charis sraegies is he weigh aached o boh sraegies. Here we examine wo possibiliies. Firs, as a naive benchmark we consider a combined invesmen sraegy ha pus equal weigh on he signals of he fundamenal and charis sraegies: (15) Naive = Fundamenalis 2 + Charis where he wo individual rading signals are defined in Equaion (11) and (14). The performance of his sraegy is displayed in Table 8. The weighs on he sraegies are updaed monhly, bu wihin he charis sraegy posiions can be opened or closed each day as before. Table 8 : Performance of he naive 50/50 sraegy , including ransacions coss. Naive 50/50 Mexico Peru Taiwan India S-Africa Israel EW VW Average 1.4% 1.7% 4.1% 2.2% 5.5% 3.8% 3.1% 2.9% Volailiy 5.1% 2.6% 3.6% 3.5% 9.5% 4.2% 2.4% 2.0% Sharpe T-saisic All saisics are annualized. Columns 2-7 repor he saisics for he individual currencies. Columns 8-9 repor respecively he equal-weighed and volailiy-weighed porfolio saisics. The ransacions coss are included and aken from Table 3. We observe ha he risk-adjused performance, as measured by he Sharpe raio, is higher han he maximum of he fundamenal and charis sraegy for wo individual currency pairs, and for four currency pairs is in beween. The equal-weighed porfolio improves o a Sharpe raio of 1.29 and he volailiy- 22

23 weighed sraegy o Hence, combining he fundamenalis and charis informaion resuls in higher risk-adjused invesmen reurns. This resul is in line wih he quesionnaire resuls obained by Taylor and Allen (1992), Lui and Mole (1998), Cheung and Chinn (2001), and Gehrig and Menkhoff (2004), which indicae ha foreign exchange dealers based in he major foreign exchange rading cenres view echnical and fundamenal analysis as complemenary sources of informaion. In he heerogeneous agens models developed in De Grauwe and Grimaldi (2005, 2006), Chiarella e al. (2006), and De Grauwe and Markiewicz (2006), agens deermine he weigh assigned o he differen available invesmen sraegies based on heir relaive pas performance. In order o es wheher his delivers superior reurns we es a second combined invesmen sraegy wih dynamic weighs placed on fundamenal and charis signals as follows: (16) exp{ F } { F } + exp{ C } exp{ C } Charis { F } + exp{ C } Dynamic = Fundamenalis + exp exp where F and C are he average number of monhs during he pas year wih posiive reurns for he fundamenal and charis sraegies, respecively. In Panels A and B of Figure 3 we show how he weighs of Equaion (16) change over ime for he six currencies. We observe ha he weigh aached o he echnical rading rules ranges beween 0.4 and 0.7, wih he average weigh being slighly larger han 0.5. This corresponds wih he finding ha mos foreign exchange dealers aach relaively more weigh o echnical analysis a shor horizons. 23

24 Figure 3: Dynamic weighs for he charis sraegy. Dynamic Weighs 0.7 Mexico Peru Taiwan May-95 May-96 May-97 May-98 May-99 May-00 May-01 May-02 May-03 May-04 May-05 Dynamic Weighs 0.7 India S-Africa Israel May-95 May-96 May-97 May-98 May-99 May-00 May-01 May-02 May-03 May-04 May-05 24

25 The performance saisics of his dynamic sraegy are summarized in Table 9. We observe ha for five ou of six currencies he Sharpe raio increases relaive o he naive equal-weighed combinaion sraegy discussed before, wih Mexico being he only excepion. Moreover, he Sharpe raios of boh he equally- and volailiy-weighed porfolio significanly increase, wih he Jobson-Korkie - saisic aking values of 2.83 and 3.05, respecively. Table 9 : Invesmen reurns for he dynamic sraegy , afer inclusion of ransacions coss. Dynamic rading Mexico Peru Taiwan India S-Africa Israel EW VW Average 1.3% 2.0% 4.5% 2.4% 7.2% 4.1% 3.6% 3.2% Volailiy 5.7% 2.6% 3.8% 3.6% 9.7% 4.4% 2.5% 2.1% Sharpe Sharpe (naive) Diff. SR (-sa) All saisics are annualized. Columns 2-7 repor he saisics for he individual currencies. Columns 8-9 repor respecively he equal-weighed and volailiy-weighed porfolio saisics. The saisical significance of he difference in he Sharpe raios beween he naïve (consan 50/50) and dynamic (ime-varying) sraegy is esed using he Jobson and Korkie (1989) mehod. The ransacions coss are included and aken from Table 3. These resuls sugges ha we can discriminae periods in which he chariss and fundamenaliss are driving he exchange rae movemens based on he hisorical performance of hese sraegies, as indicaed by Equaion (4). In oher words, our analysis suggess ha invesors may use heerogeneous agens models in order o benefi from predicing exchange rae movemens in emerging markes. As a robusness check, we es wheher our conclusions regarding he combinaion of fundamenalis and charis informaion hold for nine oher emerging currency markes. In Table 10 we display he descripive saisics of hese currencies, including he dae as of which hese currencies became floaing. We only use he currency reurns afer ha dae in our analysis below. 25

26 Table 10 : Descripive saisics for he currencies in he robusness check Hungary Poland Turkey Brasil Chile Columbia Korea Thailand Philippines Floa dae Jun-01 Apr-00 Feb-01 Jan-99 Sep-99 Sep-99 Nov-97 Jul-97 Mar-92 Transacions coss Trading volume Mean -4.6% -6.8% -27.8% -14.7% -1.8% -3.1% -4.2% -0.5% -1.5% Sandard deviaion 6.4% 10.1% 16.2% 19.3% 9.7% 8.4% 18.5% 14.1% 9.6% Skew Kurosis Jarque-Bera Mean spo rae reurn 1.9% -0.3% 5.4% 1.8% -0.1% 2.0% -2.1% 2.3% 6.3% Mean ineres rae differenial -6.5% -6.5% -33.2% -16.4% -1.7% -5.1% -2.1% -2.9% -7.8% The reurns mus be inerpreed as he reurn on a long US dollar posiion and a shor posiion in he emerging marke. Rows 2-4 repor he dae ha he currency became floaing, he ransacions coss (in bp), and he average daily rading volume (in billions of USD). The ransacions coss and rading volume are from JP Morgan (2001). Rows 5-9 repor he annualized saisics of monhly reurns on six emerging markes foreign exchange raes from he floaing dae o March The reurns include he spo rae change as well as he ineres rae differenial beween he US and he specific emerging marke counry. Rows repor respecively he average reurn on he foreign exchange rae only and he average ineres rae differenial. The robusness check is mos powerful if hese new currencies are only weakly correlaed wih he ones considered so far in he analysis. For ha reason, we calculae he pairwise correlaions beween he six currencies analyze before and he nine new currencies in Table 11. Table 11 : Correlaion marix of he monhly emerging markes exchange rae reurns Hungary Poland Turkey Brasil Chile Columbia Korea Thailand Philippines S-Africa Israel Mexico 0.27* 0.40* * 0.23* Peru * * Taiwan * 0.31* India * The pairwise correlaions are calculaed over he period ha he currency became floaing unil March * Correlaion significan on a 5% significance level From Table 11 we learn ha in general he correlaion beween old and new exchange raes is close o zero, especially across regions. Wihin regions we observe higher and someimes saisically significan correlaions. The performance of he sraegies based on fundamenal, charis, and combined informaion is shown in Table 12. We observe ha for all bu one of he counries boh he fundamenal and charis sraegies have posiive Sharpe raios. The fundamenal sraegy for Hungary is he only excepion wih a negaive Sharpe 26

27 raio of For he fundamenal sraegies he Sharpe raio is highes for Thailand wih The highes Sharpe raio for a charis sraegy is found for Colombia wih 1.21, while Korea has he lowes (0.04). The observaion ha mos Sharpe raios are posiive, and many significan, indicaes he value of boh chariss and fundamenalis informaion in our exended se of currencies. Table 12 : Robusness analysis: Invesmen reurns for differen emerging currency pairs. Model Saisic Hungary Poland Turkey Brazil Chile Colombia Korea Thailand Philipines EW VW Fundamenal Sharpe Raio Technical Sharpe Raio Consan 50/50 Average 0.2% 4.6% 5.2% 12.1% 4.5% 3.6% 5.0% 6.7% 1.5% 4.0% 3.4% Volailiy 4.0% 5.4% 14.6% 16.8% 5.6% 5.5% 11.7% 8.4% 5.9% 2.9% 2.4% Sharpe Raio Time-varying Average 0.4% 5.1% 6.5% 13.4% 5.4% 3.8% 6.3% 7.0% 1.3% 4.6% 4.0% Volailiy 4.4% 6.2% 16.2% 15.2% 5.9% 5.6% 11.9% 8.4% 6.1% 3.1% 2.6% Sharpe Raio Difference Sharpe Raio (-sa) All saisics are annualized. Columns 3-8 repor he saisics for he individual currencies. Columns 9-10 repor respecively he equal-weighed and volailiy-weighed porfolio saisics. The saisical significance of he difference in he Sharpe raios beween he consan 50/50 and ime-varying sraegy is esed using he Jobson and Korkie (1989) mehod. The ransacions coss are included and aken from Table 3. The EW and VW porfolios sar in Sepember 1999, when 6 currency pairs are available; he hree oher pairs are added o he porfolio when hey become floaing. In addiion, we find for 7 ou of 9 of hese addiional currency pairs ha he Sharpe raio increases when he dynamic weighs of Equaion (16) are employed, compared o he equal-weighed combinaion. For boh he equal-weighed and value-weighed porfolio we find ha he difference is significanly posiive a he 5% level. Thus, his robusness check confirms our conclusions from he six currency pairs invesigaed above ha here is empirical evidence in favour of he heerogeneous agens models developed by De Grauwe and Grimaldi (2005, 2006). VII. Conclusions Empirical research on forecasing exchange raes has ended o focus on he usefulness of eiher echnical analysis or of srucural exchange rae models. Boh quesionnaires among foreign exchange marke paricipans as well as recenly developed heerogeneous agens models indicae ha boh ypes of informaion are relevan for assessing exchange rae movemens. In addiion, he heerogeneous agens models sugges ha he relaive imporance of 27