A momentum trading strategy based on the low frequency component of the exchange rate

Authors' draft published as working paper; version August 2008. Final version published in Journal of Banking & Finance. Available online at http://www.sciencedirect.com/In this paper, we develop a momentum trading strategy based on the low frequency trend component of the spot exchange rate. Using kernel regression and the high-pass filter of Hodrick and Prescott [Hodrick, R., Prescott, E., 1997. Post-war US business cycles: An empirical investigation. Journal of Money, Credit and Banking 29, 1-16], we recover the non-linear trend in the monthly exchange rate and use short-term momentum in this to generate buy and sell signals. The low frequency momentum trading strategy offers greater directional accuracy, higher returns and Sharpe ratios, lower maximum drawdown and less frequent trading than traditional moving average rules. Moreover, unlike traditional moving average rules, the performance of the low frequency momentum trading strategy is relatively robust across different time periods. The low frequency momentum trading strategy is also robust to the choice of smoothing parameter (in the case of the HP filter) and the distribution and bandwidth parameter (in the case of kernel regression) over a wide range of values. (C) 2009 Elsevier B.V. All rights reserved