How is the value factor defined for currencies?

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AcadiFi · Accepted Answer

Currency value measures deviation from a theoretical 'fair value' anchor. Three common metrics: (1) Purchasing Power Parity (PPP) — compares exchange rate to ratio of price levels between two countries; undervalued means a dollar buys more goods in country A than country B suggests; (2) Real Effective Exchange Rate (REER) — trade-weighted inflation-adjusted exchange rate vs a basket, with historical mean-reversion anchors; (3) Behavioral anchors like Big Mac Index (simplified PPP). A systematic value strategy might rank G10 currencies by 5-year percentile of REER deviation from long-run mean, go long the cheapest, short the most expensive. Evidence: value earns 2-4% annually with Sharpe 0.3-0.5, lower than carry and momentum but with near-zero correlation to both, making it a valuable diversifier. Value works because PPP holds over multi-year horizons — overvalued currencies eventually correct through price adjustments (domestic inflation), capital flow reversal, or monetary policy response. Limitations: horizon can be very long (5-10 years for full reversion), central bank regimes (pegs, dirty floats) can delay convergence indefinitely, and productivity divergences (Balassa-Samuelson) create persistent PPP deviations that aren't really mispricings. Construction variations include relative value pairs (long undervalued Swedish krona vs overvalued Swiss franc), trade-weighted baskets, and fundamental models incorporating terms of trade and productivity. A multi-factor fund running Faulkes Systematic FX might equal-risk-weight carry, momentum, and value, achieving combined Sharpe around 1.0 with diversified drawdown profiles.

How is the value factor defined for currencies?

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