"Technical Analysis in Financial Markets"

2.4.2 Pound-Dollar exchange rate

This section describes how the excess return of a trading strategy applied to an exchange rate E_t is computed. On a buy signal the foreign currency is bought and the foreign risk-free interest rate r_f,t^F is earned. If there is a position in the foreign currency and the trading rule generates a sell signal or advises to hold no position, then the foreign currency will be exchanged for the domestic currency and the domestic risk-free interest rate r_f,t^D is earned. Costs are calculated as a fraction c of the exchange rate. The following formula gives the gross return of the trading strategy used:

(1-costs)=

⎧
⎪
⎪
⎨
⎪
⎪
⎩

1+c

, if foreign currency is bought;

1-c

, if foreign currency is sold;

, if there is no change in position.

1+r_t=

⎧
⎪
⎨
⎪
⎩

E_t

E_t-1

(1+r_f,t^F) (1-costs),

if a position is held in the foreign currency;

(1+r_f,t^D) (1-costs),

if a position is held in the domestic currency.

(7)

The net return with continuous compounding can be computed by taking the natural logarithm of (2.7). The excess return over the risk free domestic interest rate and after correcting for transaction costs of trading currency we compute as r_t^e=ln(1+r_t)-ln(1+r_f,t^D). With equation (2.6) we can determine how much better a trading strategy performs over a continuous risk free investment, for example a domestic deposit. For the foreign and domestic interest rates we use as proxies the US and UK 1-month CODs, which are recomputed to daily interest rates. Costs for trading are set equal to 0.1%.

2.5 Profitability and predictability of trading rules

2.5.1 The best 5 strategies

Panel A of table 2.3 shows the results of the best five technical trading strategies applied to the CSCE cocoa futures price series in the period 1983:1-1997:6. Panel B of the table lists the results of the best strategy in each subperiod. The first column of the table lists the strategy parameters. MA, TRB and FR are abbreviations for the moving average, trading range break-out and filter rules respectively. %b, td, fhp, and stl are abbreviations for the %-band filter, the time delay filter, the fixed holding period and the stop-loss respectively. For example, the best technical trading strategy in the full sample period is the trading range break-out strategy with a history of five days, a two %-band filter and a 50 day fixed