Many investors, wary of the volatility in the stock markets, are looking for a safe asset class to place their hard-earned nest eggs. Foreign exchange, or forex, is one such class right now. However, for many investors, forex is an unknown and untested entity. This article offers a case study to illustrate an approach to invest in a foreign currency, US-to-Canadian dollar exchange rate, denoted USD/CAD.
Figure 1 shows the price levels of USD/CAD over the past two years. To an untrained eye, these price levels are random and can be intimidating. Academics have proposed various diverging strategies for predicting the fair price levels of currencies, including USD/CAD, yet, most of these theories have failed the test of time and data.
One particular economic theory still appears to have legs and may prove useful to investors interested in forex: the Purchasing Power Parity (PPP). PPP states that the forex rate is really a reflection of the two countries relative inflation rates. Both the U.S. and Canadian governments report inflation as a change in the monthly Consumer Price Index (CPI). While the PPP addresses respective inflation rates, this article shows that the U.S. inflation rate alone has a significant enough impact on USD/CAD to warrant a sound investment strategy.
Figure 2 illustrates the monthly changes in the U.S. CPI over the past two years. While it is difficult to estimate the relationship across the inflation rates and the USD/CAD just from the charts, some additional math uncovers the following dependency: following each announcement of rising U.S. CPI, USD/CAD falls with a very high probability, often approaching 99.99%.
Figure 3 illustrates the phenomenon: following each increase in the U.S. CPI, USD/CAD drops sharply for 5 trading days following the CPI increase announcement (conversely, USD/CAD rises for 5 trading days following an announcement of a fall in the U.S. CPI). On average, for every 1 point increase in the U.S. CPI, USD/CAD falls over 600 bps over the following 5 days, as measured from the closing price of USD/CAD on the day preceding each U.S. CPI announcement. In addition, as the right-hand axis of Figure 3 shows, the response of USD/CAD is extremely statistically significant: the likelihood of USD/CAD falling (rising) within the first few days after a rise (fall) in the U.S. CPI is well over 95%.
To actively invest in USD/CAD, investors should closely monitor the U.S. CPI announcements. The next U.S. CPI announcements are expected at 8:30 AM on November 17 and December 15, 2010; see The Quant Investorâ€™s Almanac 2011 for all the dates and times of the U.S. CPI releases in 2011. As soon as possible after a U.S. CPI release, place a trade in USD/CAD: after a positive change in the U.S. CPI, sell USD/CAD (buy Canadian dollars with U.S. dollars); after a negative change in the U.S. CPI, buy USD/CAD (sell Canadian dollars and buy U.S. dollars instead). On the fifth trading day after the announcement, reverse your position, capturing the gain.
Irene Aldridge is a quantitative portfolio manager and managing partner at Able Alpha Trading, LTD., a U.S. Registered Investment Advisor in New York City. Aldridge is also a co-author of The Quant Investorâ€™s Almanac 2011: A Roadmap to Investing (Wiley & Sons, October 2010).