What's beta in FX?

For my very first post on the Thalesians blog, I feel that I should tackle the notion of what is beta in FX. If you haven't spent a long time in FX markets, it can seem somewhat confusing to understand what should be a benchmark or "beta" to use a bit of market jargon. In equities, we have the S&P500 which can be used as a beta for long only investors. Similarly, in bond markets, we have various global indices produced by a multitude of banks, including Citi, Barclays and JPMorgan. Even in these cases though a beta is still something which isn't quite concrete.

In FX, there is no such obvious "beta". Furthermore, the notion of a long only investor can be confusing in FX. It is difficult to identify a "long only" investor in FX. After all, if you undertake an FX trade, for example long EUR/USD, you are simultaneously long one currency and short another. Hence, in order to understand what market beta is in FX markets, we need to adopt a slightly different approach. First, we need to have an idea of the typical factors which FX funds use to trade. 

Perhaps, the most common strategies which are used to trade FX, are those which involve carry and trend, as well as value. Of course there are many other common FX strategies, such as using relative interest rate differentials, modelling flows and using macro based models. Our aim is not to create an exhaustive list, but simply to understand the most common. By definition a "beta" strategy is one which can capture the returns of the market and generally requires less "work" than an "alpha" strategy.

If we purely focus on carry and trend, possibly the most popular FX strategies, we can create very generic versions. Carry involves buying high yielding currencies and selling low yielding currencies. In effect, it is a way of capturing a risk premium within FX markets. Hence, it can suffer from asymmetric returns, steady profits, but then suffering large drawdowns when there is risk aversion. A generic version of carry, simply needs to create a rank of the deposit yields on currencies. Trend strategies, as the name obviously suggests, attempt to buy high (and sell even higher), and sell low (and buy even lower). We can create a generic trend model using relatively simply technical indicators such as moving averages.

Once we have created these generic carry and trend models, we can regress them against the returns of a FX fund index (such as HFRX Currency Index). This enables us to find weights for our generic carry and trend models, which should proxy FX fund returns. We can then create a weighted portfolio of carry and trend, which as we see below does actually proxy FX fund returns pretty well! Hence, at least on a broad based level, it does appear that carry and trend seems to capture a lot of what FX funds do (see plot at the top!).

To read more about this topic please see the below work I've done, which goes through the subject in more detail. My book Trading Thalesians also has a chapter on alpha and beta (mixed in with a bit of ancient history).

Thalesians - Beta'm Up - What is market beta in FX - 30 Aug 2013 (Download from SSRN)
Handbook of Exchange Rates (Wiley) - chapter on FX market beta by Saeed Amen & Geoff Kendrick