We have developed a new financial indicator – called the Interest Rate Differential Adjusted for Volatility (IRDAV) measure – to assist investors in currency markets. On a monthly basis, we rank currency pairs according to this measure and generate a basket of pairs with the highest IRDAV values. Under positive market conditions, an IRDAV based investment strategy (buying a currency with high interest rate and simultaneously selling a currency with low interest rate, after adjusting for volatility of the currency pairs in question) can generate significant returns. However, whenever the markets turn for the worse and crisis situations evolve, investors exit such money making strategies suddenly, and – as a result – significant losses can occur. In an effort to minimize these potential losses, our research work generates an aggregate risk metric that evaluates (estimates) the total risk by looking at various indicators across different markets. These risk indicators are used to get timely signals of evolving crises and to flip the strategy from long to short in a timely fashion, to prevent losses and make further gains even during crisis periods. Since our model is implemented in Excel as a highly nonlinear computational procedure, we utilize global optimization software (Excel-LGO) to maximize the performance of the currency basket, based on our selection of key decision variables. We introduce the new currency trading model and its implementation, and then present numerical results based on actual market data.
Technical Report, Özyegin University, Istanbul, Turkey, June 2010. Submitted for publication.