Focusing on Fundamentals
External Imbalances as a Driver of Exchange Rates
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
Average Monthly Spot Currency Returns