Currency strategies and their risk factors

Abstract

Executive Summary In this paper, I try to establish a procedure to invest in EURUSD currency pair during a period where there is monetary policy shifting in Europe and USA. As remarked by Redl (2015), this kind of transition period conducts to imperfect information circulation and disconnection between the currencies exchange rate level and market fundamentals. There are many reasons to explain the increase in volatility which started at the beginning of 2015 for the EURUSD currency pair. One of them is the different monetary policy followed by the Federal Reserve System (FED) and European Central Bank (ECB). At the beginning of 2015, FED has stopped its quantitative easing (QE) program and has also tightened its monetary policy by increasing the interest rate; meanwhile the ECB has started its QE program (Buttenwood, 2015). In this market situation, traditional strategy such as momentum failed to make profit. In this paper, I look at volatility as my friend and not my enemy and try to develop active management based on option strategy. This master thesis tries to understand and model the factors influencing options strategies. These factors are the underlying price, change in volatility and the time to maturity. This paper proposes different models to try to estimate these factors, such as ARMA, GARCH modelling to propose, at the end, a methodology to invest in a market where high volatility is encountered. The results of my different models have showed that firstly, the residuals of the EURUSD exchange rate is a white noise and therefore, cannot be modelled with an ARMA model. This has led to another approach to forecast the expected exchange rate. In response to that, I have used the Market-Based approach to forecast exchange rate level with Euro FX futures contracts. Secondly, GARCH modelling provides me a way to forecast the volatility tendency. The methodology, combining information gathered from the Euro FX futures contracts and GARCH modelling, demonstrates that most of the implemented strategies has a positive profit when options are exercised at maturity.

Key words: EURUSD; Options strategies; Volatility; GARCH modelling