Author: shyam

Please read Part I for the introduction, Part II for a study of the spread between USDINR and the dollar indices and Part III for a spread-trading back-test on daily returns.

Weekly vs. Daily

In our previous posts, we used daily returns to setup the analysis. However, analyzing daily series on currencies and commodities is problematic. They trade 24/7 in a global marketplace and “closing” prices for commodities and currencies are hard to pin down at a granular level across markets. One way to ameliorate this issue is to use a weekly or a monthly series instead.

Here are the plots of the spreads and p-values from the adf-tests applied to weekly returns:

The back-test results mirror that of the daily series, with bets on momentum carrying through on the USDINR and DTWEXM pairs:

This gives us more confidence in our back-tests. We end our series with the following caveats:

1. Trading the spread involves trading both legs (as discussed in Part III.)
2. One can only buy a currency by selling another. i.e., buying USDINR implies going long USD and short INR.
3. Using the above analysis, if a trade involves buying USDINR in one of the legs, it does not inform anything on relative valuation of USD or INR.

Code and charts on github.

Please read Part I for the introduction and Part II for a study of the spread between USDINR and the dollar indices.

Trading the spread

In Part II, we defined spread = A – βB. When we say “trade the spread” we literally mean going long or short the spread as defined. To actually implement the trade, one would have to create two legs: one that is long USDINR (A) and the other that is short β times one of the dollar indices (B). Since the dollar indices are not something that can be actually traded, the following back-tests are purely a theoretical exercise.

Back-test

We consider three scenarios:

1. C1: if the spread diverges beyond 1-sigma, bet on mean-reversion.
2. C2: if the spread diverges beyond 1-sigma, bet on it getting bigger.
3. D1: if the spread is between the average and 1-sigma, bet on it blowing out.

The first one is pure convergence and the last one is pure divergence. The second one is sort of like momentum – if the spread is already beyond 1-sigma, bet on it further blowing out.

It appears the second scenario, the one that bets on momentum carrying through, is the most profitable. Also, the most profitable pair seems to be USDINR and DTWEXM (Trade Weighted U.S. Dollar Index: Major Currencies).

In the last part in this series, we will run through this analysis for a weekly time-series of these indices.

Code and charts are on github.