The systematic currency strategy takes advantage of the extreme liquidity of the forex market. Additionally, investing in foreign exchange markets protects against adverse currency movements. In investing in the forex market, there is a comparison of systematic currency trading versus currency arbitrage trading. This article details systematic currency trading and its advantages and disadvantages against currency arbitrage trading.

Systematic currency trading models rely on macroeconomic indicators to determine trends in a country's economy and then execute trades based on those trends. Typically, the models are implemented using software and retrieve indicator data from a financial terminal, such as Bloomberg.

The indicator data is parsed by an algorithm that predicts and confirms economic trends.

Based on these trends, the model executes the appropriate trade. Since indicators constantly change and there exists extreme volatility in the forex market, the trades are normally short-term holdings. To further understand how these short-term holdings are determined, one must study the economic indicators typically used in systematic currency models.

Systematic currency models employ two types of macroeconomic indicators: The leading indicators are key economic statistics that predict changes in the economy before the economy undergoes a particular trend. Examples of leading indicators are the Purchasing Managers Index PMI and the yield curve. The PMI signals economic health in the manufacturing sector and is typically used in predicting the gross domestic product GDP of an economy.

Increases in PMI suggests an increase in GDP which then suggests a strong economy. On the contrary, a decrease in PMI suggests a weak economy. The yield curve alludes to future interest rates and economic activity. A yield curve with a positive slope suggests economic expansion while a negative slope suggests a recession. The steeper the slope, the more extreme the consequence. The lagging indicators are economic factors that change only after the market has begun a trend.

Examples of lagging indicators are the GDP and the consumer price index CPI. Changes in the GDP are typically used to confirm predictions set forth by the PMI.

The CPI evaluates the cost of living. Movement in the CPI signals a movement in inflation. An increase in inflation or deflation suggests an economic downturn. A healthy economy has steady inflation.

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The macroeconomic indicators suggest trends in the market allowing the systematic currency models to complete unbiased investment decisions. Additional indicators are used at the digression of the model developer. While it is important to consider indicators in building a systematic currency strategy, it is equally important to consider the market in which the indicators exist to determine if the strategy will be successful.

Systematic currency trading is successful in free moving markets, or markets that are not subject to government intervention through active manipulation and market-distorting policies. Markets that move freely are prone to short-term volatility. These cause changes in the indicators mentioned above which signal revenue generating trades. Thus, cultivating a revenue-generating environment for forex trading. Typically, investors stick to G10 currencies U.

S dollar, the euro, the Japanese yen, the British pound, the Swiss franc, the Australian dollar, the New Zealand dollar, the Canadian dollar, the Swedish krona, and the Norwegian krone because these market environments fit the criteria highlighted above and provide quality market data that can be used to determine indicators.

Once investors develop a robust model and determine which markets to include, investors then set criteria for clients that wish to invest in the model. To understand recent performance of systematic currency models, one must study the volatility in the market. The figure below overviews the returns generated by the Barclays Currency Traders Index BCTI from The BCTI is a benchmark for currency traders as it is a strong indicator if the forex market contains enough volatility to yield substantial returns.

Now, compare these returns to the volatility in the market to determine the correlation between volatility and returns in systematic currency trading. The figure below represents the Deutsche Bank FX Volatility Index.

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I focus on the years to include years from the golden period of forex trading and the years following. These years highlight the final years of extreme forex volatility followed by a less volatile period and then a spike of volatility.

Comparing the two figures above shows a high correlation between systematic currency trading and foreign exchange volatility. The years have high volatility and high returns NYSEARCA: Then, the decrease of volatility in is coupled with low returns. Finally, the spike in volatility in is matched with high returns. Nevertheless, the returns are highly correlated with forex volatility.

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To determine the value of systematic currency trading, compare the historical returns of the BCTI to the historical returns. The BCTI has a correlation coefficient of This proves true in examining the historical returns. It is important to notice that the SPY has larger returns. The BCTI proves to have steady smaller returns rather than large leaps like the SPY. However, in years of the tech bubble and the post financial crisis, the BCTI yields positive returns.

As detailed above, this is because of the extreme volatility that accompanies recessions. Thus, while systematic currency trading may not always outperform the SPY, its returns are consistent and resilient. The success of both systematic and arbitrage models depends heavily on market volatility. Periods of market stability may cause material effect for the success of the currency models. The systematic models predict movements in the market using economic indicators.

However, movements in the markets are often not caused by changes in the economy. Changes in domestic and global politics play a huge role in market movement. The economic indicators cannot capture the movements driven by politics. These movements are often difficult to predict, even using quantitative models. The systematic models will only be able to detect market movement driven by politics when they cause changes in the economic indicators.

Thus, the systematic models are slow to react to political driven trends. This makes a strong case for sticking to currency arbitrage trading. While the arbitrage models do not predict movements in the market, they are still able to detect arbitrage and yield profit.

Investors that believe the market trends will continue to be direct responses to political movements may want to stick to the arbitrage models.

This proves especially true for emerging market currencies NYSEARCA: CEW since their value often depends heavily on their developing governments.

Also, the information released by emerging market economies is often unregulated. Thus, the economic indicators are an unreliable predictor. This is detrimental to the systematic strategy because it depends so heavily on accurate indicators. However, the arbitrage spread in emerging market economies is generally much higher than that in developed market economies.

Thus, emerging market economies provide fruitful opportunities for currency arbitrage. To the contrary, G10 currencies are backed and regulated by strong governments. Thus, the economic data is accurate and thrives in the systematic models. Thus, systematic models are best used in conjunction with G10 currencies during times of economic volatility. I wrote this article myself, and it expresses my own opinions.

I am not receiving compensation for it other than from Seeking Alpha. I have no business relationship with any company whose stock is mentioned in this article. An Alternative To Currency Arbitrage - Systematic Currency Trading May. Summary An overview of systematic currency trading. The recent performance of systematic currency trading models. Systematic Currency Trading Systematic currency trading models rely on macroeconomic indicators to determine trends in a country's economy and then execute trades based on those trends.

Recent Performance of Systematic Models To understand recent performance of systematic currency models, one must study the volatility in the market. Historical Returns SPY vs. BCTI The BCTI has a correlation coefficient of Systematic Currency Trading The success of both systematic and arbitrage models depends heavily on market volatility.

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