AUD/JPY: "bipolar disorder" history

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Written by Forex Automaton   
Wednesday, 15 October 2008 08:26

Any statistical test of market inefficiency requires a finite time of observation. The series of notes surveying historical inefficiencies of forex, posted here under the rhetorical title "Have the forex markets been efficient?", were based on data covering time interval from August 2002 to February 2008. In many cases, significant deviations of autocorrelations from the "dumb" pattern prescribed by the efficient market assumption (zero correlation at any time lag except for zero) have been detected, having survived the time averaging process. To be of practical value for forecasting and algorithmic trading, these features have to be expectable in the future, at least in principle. A rare but huge event and a frequent one of a moderate magnitude may leave the same trace on the autocorrelation. At the very least, one must ensure that these time-averaged signals are not merely diluted residues of certain once-in-a-lifetime events. If they are merely that, a trading system with regular decision-making and execution, such as the one being built here on the Forex Automaton™ site, is not the optimal strategy to take advantage of them. This article, dealing specifically with what is perhaps one of the most conspicuous of such patterns, the hour-scale "bipolar disorder" in the carry-trade pair AUD/JPY, begins a new series of notes focusing on the time evolution of the now uncovered forex patterns one at a time.

AUD/JPY historical chart 2002-2008

Fig.1: Bar chart of AUD/JPY history. The time axis is labeled in MM-YY format.

AUD/JPY autocorrelations of logarithmic returns in 2004 (2nd quarter) and 2008 (2nd quarter)

Fig.2:Autocorrelations of logarithmic returns in AUD/JPY, over a range of time lags, computed for the second quarter of 2004 and the second quarter of 2008. Time scale of the analysis is hour.

For the sake of completeness, Fig.1 presents the history of AUD/JPY for the period under study. Fig.2 portrays the subject of this note -- the "bipolar disorder", using the psychiatric analogy ascribed to Benjamin Graham ("Intelligent Investor"). Justifying the psychiatric analogy, the huge negative autocorrelation signal in the bin next to zero indicates rapid (next hour) changes in the mood of the market, a price action followed by an immediate correction. Technically, these represent a profit opportunity to a speculator able to stay cool and take advantage of the market's excesses, entering after the "action" and taking profit on the predictable "reaction". What is not clear from Fig.2 is whether these events happen regularly.

One hour time lag magnitude of the AUD/JPY autocorrelation of logarithmic returns, 2002-2008

Fig.3:One hour time lag magnitude of the autocorrelation of logarithmic returns in AUD/JPY, plotted as a function of time, October 1, 2002 through October 1, 2008. Time axis is labeled in MM-YY format. The number of bins (24) equals the number of quarters in the six-year period. The noise (red in the figure) is obtained from martingale simulations based on the historical volatilities of AUD/JPY for the period under study. The noise is presented as mean plus-minus 1 RMS, where the RMS characterizes distribution of the correlation value obtained for this particular time lag bin by analyzing 20 independent simulated pairs of uncorrelated time series. The RMS is a measure of accuracy in the determination of the correlation values, an uncertainty dependent on the amount of data and the time scale.

Presenting the magnitude of the one hour time lag autocorrelation as a function of time, Fig.3 has a couple of important messages:

  • We are not dealing with just a single once-in-a-lifetime event. The inefficiency in question ("bipolar disorder") is historically continuous.
  • The heyday of the feature seems to be the period of late 2003 -- early 2005, as can be judged from the magnitude of the correlation. Let's however make sure this is not just due to an overall increase in volatility. Ideally, we want the feature to be big with respect to "the rest" of market movements, not just reflect an overall increase in volatility. Therefore we continue with Fig.4.

 

Volatility of logarithmic returns in AUD/JPY, 2002-2008, as a function of time. Hour time scale.

Fig.4:Volatility of one hour time scale logarithmic returns in AUD/JPY, plotted as a function of time, October 1, 2002 through October 1, 2008. Time axis is labeled in MM-YY format. The number of bins (24) equals the number of quarters in the six-year period. The red band, not particularly important here, denotes the average volatility level for the entire period, as opposed to individual date intervals.

As Fig.4 shows, the heyday of the bipolar disorder feature in AUD/JPY is the period not noted for volatility excesses. At the time of high volatility, starting in Summer 2007, the effect under study was not there (see Fig.3). In fact it was not there for all of 2007. At this point, if not already, one begins to think of carry-trade -- the practice of borrowing low-interest Yen and investing into the high-yielding Aussie. There is in fact one more connection -- the pattern of bipolar disorder is the trade-mark of LIBOR correlations.

History of s/n-o/n LIBOR interest rates in AUD, 2002-2008 History of s/n-o/n LIBOR interest rates in JPY, 2002-2008 History of difference in s/n-o/n LIBOR interest rates between AUD and JPY, 2002-2008

Fig.5:Historical LIBOR rates, s/n-o/n, top to bottom: Australian Dollar, Japanese Yen, and the interest rate differential between AUD and JPY.

Looking at the history of LIBOR rates (Fig.5), increased volatility is seen in both AUD and JPY, starting in the second half of 2007. In JPY the noteworthy point is the second half of 2006, when the LIBOR went up sharply. After that JPY LIBOR is also seen to be a lot more volatile. While the LIBORs do not prove anything, they are consistent with the carry-trade explanation: even though the interest rate differential remains high throughout 2007 and 2008, the high volatility of the AUD/JPY exchange rate seen since the second half of 2007 may impede carry trade.

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Last Updated ( Monday, 14 September 2009 16:53 )