Research paper on CLS’s FX dataset reveals profitable FX trading strategy based on information asymmetry

CLS, market infrastructure provider of risk mitigation services to the global FX market, announced that researchers at the University of St.Gallen analyzed CLS’s FX dataset to identify information asymmetry in the FX market and estimate its impact on FX price movement and published a paper with their findings.

Angelo Ranaldo, Professor of Finance and Systemic Risk and Fabricius Somogyi, a third-year PhD candidate, used CLS FX Spot Flow data to show that a trading strategy based on asymmetric information risk can potentially offer strong diversification for FX trading strategies. The strategy generated consistent outperformance when applied against the past six years of historical data compared to traditional trading strategies such as FX carry, value and momentum.

The paper is based on the idea that some groups of market participants are better informed and continue to serve as dealers’ “smart money” in the FX market. The paper lays out strategies to convert “smart money” into “smart beta” by investing in currencies with higher levels of asymmetric information risk and gaining higher expected returns.

Ranaldo and Somogyi’s research finds that this strategy remains profitable (as applied against the historical data) even after applying transaction cost estimates, generating an after t-cost Sharpe of 0.65 and excess returns of 3.16% per annum. The strategy is also negatively correlated to traditional trading strategies like FX carry, value and momentum.

These findings may be appealing to market participants seeking consistent returns in situations. Backtesting results reveal that the strategy was also effective during periods of unusual monetary policy and is unaffected by specific regulatory issues or institutional events like for example, when the Swiss National Bank announced that it would no longer hold the Swiss franc at a fixed exchange rate with the euro in January 2015.

University of St.Gallen analysis of CLS’s FX dataset reveals that information asymmetry can offer strong diversification for FX trading strategies

The fragmented nature of the FX market poses serious challenges for sourcing comprehensive data, however, the research findings were made possible with CLS’s FX Spot Flow data. CLS is a large source of FX executed trade data and provided the researchers with access to insights into FX market dynamics, including the interactions between different categories of market participants such as banks, corporates, funds and non-bank financial firms.

Professor Angelo Ranaldo, University of St.Gallen, commented:

This project began as a seminar paper, but we realized the depth of the dataset from CLS made it possible for us to study the FX market at a more comprehensive level, resulting in exciting new insights into a traditionally opaque market. We believe our research will be particularly beneficial to risk managers, currency hedge fund managers, and the regulatory community.

Masami Johnstone, Head of Information Services at CLS, added:

Masami Johnstone, CLS

Masami Johnstone
Source: LinkedIn

CLS’s unique position at the center of the FX market means we have a key role to play in increasing transparency in the market. The research from the University of St.Gallen is another example of how CLSMarketData provides insights for a clearer view and more meaningful analysis of the FX market, enabling portfolio managers and traders to calibrate and refine their investment and trading strategies.

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