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Research Summary

  • Forex / Currency

Focusing on Fundamentals

External Imbalances as a Driver of Exchange Rates

Senior Quantitative Analyst
June 15, 2010

As with all asset classes, currency investing involves a risk-reward decision: When one currency pays a higher interest rate than others, is it an opportunity or a warning signal? The better we understand a currency’s fundamental risks, the better our chances of improving risk-adjusted returns while limiting our downside.

At AllianceBernstein, we have recently developed a proprietary indicator, the external imbalance indicator (EII), designed to capture fundamental influences on exchange rates. The EII aims to forecast exchange-rate changes based on observed disequilibria in a country’s foreign trade and net-foreign-asset positions.

The research results have been encouraging: based on historical data, our simulations suggest that the indicator was a good predictor of exchange rates (Display). And, when incorporated into a multifactor currency strategy, simulations using the indicator resulted in improved risk-adjusted returns and lowered downside risks.

In Simulations, the External Imbalance Indicator Was a Good Predictor of
Exchange-Rate Moves
Average Monthly Spot Currency Returns
Currencies are ranked into quartiles according to the strength of their external fundamentals as captured by their EII readings.
Results are based on monthly data for the advanced-economy currencies from April 1976 to March 2010.
Source: Bloomberg and AllianceBernstein

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