What are the main currency factors and how do they behave?

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AcadiFi · Accepted Answer

Currency factor investing applies systematic style investing to FX markets through three primary factors — carry, momentum, and value — plus occasional additions like quality and defensive. Carry: buy high-yielding currencies, sell low-yielding. Historical Sharpe ~0.5-0.7, with crash risk during global risk-off episodes (see 2008 AUD/JPY collapse). Momentum: buy currencies trending up vs domestic, sell trending down. Sharpe ~0.3-0.5, with smoother returns than carry but episodic whipsaws. Value: buy undervalued currencies (vs PPP or real exchange rate), sell overvalued. Long-horizon Sharpe ~0.3-0.4, but requires patience — reversion often takes years. A diversified currency factor portfolio might equal-weight carry, momentum, and value, producing Sharpe 0.8-1.0 due to low correlations between factors. Construction: G10 universe typically, equal-risk-weighted, rebalanced monthly. Factor returns correlate loosely with equity factors (carry has some equity beta; momentum and value have near-zero). Currency factors struggled 2010-2020 as unconventional monetary policy flattened rate differentials and compressed volatility. Recent revival post-2022 as divergent central bank paths restored carry opportunities. Implementation via deliverable forwards, NDFs (for restricted currencies), or via swap-based structures for large AUM. Capacity is high — FX is the largest market globally at $7.5T daily turnover. Risk management emphasizes drawdown control, currency-pair concentration limits, and turnover-aware signals.

What are the main currency factors and how do they behave?

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