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BAM Intelligence

When Risk Goes Unrewarded

Risk-based asset pricing theory suggests, simply, that assets bearing a higher risk should compensate investors with higher returns.

While most papers investigating the risk-return relationship of assets are focused on equity markets, surprisingly few studies explore this phenomenon in currency markets (which are among the deepest and most liquid markets in the world). In fact, the FX markets are larger than the global equity markets, at least in terms of traded volume.

On the other hand, there have been many studies demonstrating the robustness of what is called the carry trade (borrowing in a low-interest-rate currency and investing in a currency that provides a higher rate of return) in the FX markets. In short, currencies with higher yields deliver higher returns.

Research has also found that FX volatility correlates with the carry trade. In addition, there is strong evidence that the momentum effect also exists in FX markets—as it does everywhere else we look, be it in different asset classes or regions of the world.

Klaus Grobys and Jari-Pekka Heinonen—authors of the October 2015 study “Is There a Credit Risk Anomaly in FX Markets?”—contribute to the literature by exploring whether a link between sovereign credit ratings and currency returns actually exists.

Unfortunately, the availability of credit rating data dictated the sample period, which was the relatively short time frame of January 1998 through December 2010. The authors divided a sample of 39 currency returns into three portfolios consisting of currencies sorted by the previous month’s Oxford Economics sovereign credit ratings.

Portfolios were formed by being long the one-third of currencies with the lowest credit rating and being short the one-third of currencies with the highest credit rating. Following is a summary of the authors’ surprising findings:

  • While premiums were found for the carry trade, volatility (long high volatility and short low volatility) and momentum, there was a negative premium of 0.30% per month for the credit strategy. And importantly, the data was statistically significant at the 1% level.
  • Average portfolio returns sorted by credit risk decrease linearly as they move from the low to the high credit risk portfolio. This suggests higher credit risk is associated with lower returns. In addition to negative returns, the long low-credit-quality and short high-credit-quality portfolio has a non-normal distribution. There is negative skewness (-0.5) and excess kurtosis (2.9), or a fat tail.

The authors concluded: “Even though risk-based asset pricing theory suggests that riskier assets should generate higher payoffs than less risky assets, our results suggest that currencies of countries with a high credit risk tend to generate lower returns than currencies of less risky countries.”

Surprisingly, this anomaly exists despite the fact that in currency markets there aren’t the same constraints against shorting that exist in the equity markets, constraints that can allow anomalies to persist.

It’s interesting to note as well that this outcome isn’t all that inconsistent with the finding that, even before costs, there has been only a very small credit premium in U.S. credit markets. For example, even before implementation costs, the credit premium between investment-grade corporate bonds and Treasurys has been only about 0.3%.

The bottom line is that this paper contributes to the evidence showing that credit risk has not been well-rewarded, whether we are talking about bonds or currencies.

This commentary originally appeared November 25 on ETF.com

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2015, The BAM ALLIANCE

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Chief Research Officer

Larry Swedroe is Chief Research Officer for the BAM ALLIANCE.

Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.

To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has authored 15 more books:

What Wall Street Doesn’t Want You to Know (2001)
Rational Investing in Irrational Times (2002)
The Successful Investor Today (2003)
Wise Investing Made Simple (2007)
Wise Investing Made Simpler (2010)
The Quest for Alpha (2011)
Think, Act and Invest Like Warren Buffett (2012)
The Incredible Shrinking Alpha (2015)
Your Complete Guide to Factor-Based Investing (2016)
Reducing the Risk of Black Swans (2018)
Your Complete Guide to a Successful & Secure Retirement (2019)

He also co-authored four books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006), The Only Guide to Alternative Investments You’ll Ever Need (2008), The Only Guide You’ll Ever Need for the Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for MutualFunds.com and Index Investor Corner on ETF.com.

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