Currency Value Trading with Purchasing Power Parity

Summary

This document presents a foreign-exchange value strategy that uses purchasing power parity (PPP) to compare currencies with estimated fair values. The suggested universe contains 10–20 currencies. Using the latest OECD PPP figure and monthly CPI and exchange-rate changes, it updates estimated values against the US dollar. It then buys the three currencies judged most undervalued and sells the three judged most overvalued, placing unused cash in overnight-rate instruments. Rebalancing may be monthly or quarterly.

The rationale is that relative price differences and currency valuations can provide information about future FX returns over longer horizons. The cited research finds that real-exchange-rate valuation measures predict cross-sectional excess returns and spot-rate changes, with much of the predictability tied to persistent differences in national fundamentals. This complicates a simple convergence explanation: the research does not support the claim that simple value profits necessarily come from exchange rates reverting to fair value. Other cited evidence finds that value-strategy results can vary by sample and may weaken after costs. The document suggests diversification benefits but gives no strategy-specific risk estimates.

Key ideas

• PPP provides a way to estimate relative currency value from cross-country price levels.
• The proposed portfolio buys the three most undervalued currencies and sells the three most overvalued currencies in its universe.
• The strategy can be rebalanced monthly or quarterly, with unused cash invested at overnight rates.
• Research associates currency value with predictable excess returns and persistent differences in national fundamentals.
• Simple currency value signals may not profit solely through exchange-rate convergence, and results can depend on sample selection and trading costs.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.