Market Timing and Predictability in FX Markets

We construct mean-variance optimized currency portfolios and analyze the time- series variation of the conditional Sharpe ratio. Returns, volatility and skewness are predictable. Market timing – i.e., trading more (less) aggressively when the conditional risk-return trade-off is more (less) favorable – significantly increases the unconditional Sharpe ratio from 0.72 to 1.21, improves the skewness of the monthly return distribution from -0.79 to +0.89, and reduces the downside risk from 8.68% to 1.57% maximum loss per 1% expected excess return. Thus, restricting risk taking, i.e., prohibiting market timing, is costly. Understanding and quantifying these costs is important when considering constraints in asset allocations