RDP 2004-07: The Profitability of Speculators in Currency Futures Markets 1. Introduction

“Amoral maybe, but currency speculators are both necessary and productive” The Economist September 25 1997

Speculators have long been a controversial group in currency markets. Friedman (1953) famously suggested that speculators would be a stabilising force in currency markets, while Nurske (1944) argued the opposite. The disaggregated nature of foreign exchange spot markets and the consequent lack of representative data have impeded research on the role of speculators. However, futures trading does occur on organised markets so authorities are able to collect data on the positions of different types of agents. We use these data on the positions of speculators to estimate the profitability of these controversial traders.

The profitability of speculators in exchange rate futures might also provide some insight into the broader operation of currency markets. Interest differentials are highly persistent and so changes in currency futures prices are almost entirely driven by volatile spot exchange rates. By definition, speculators in currency futures markets trade only to make profits and not for fundamental purposes such as to hedge foreign exchange risk. Since they have no other reason to trade futures, we would expect that if any group of agents is to be profitable in currency markets, it should be speculators. If speculators are indeed profitable, then they must have some working ‘model’ of exchange rates that allows them to predict movements, however imperfectly. Ever since the work of Meese and Rogoff (1983) the conventional wisdom has been that changes in exchange rates, and so currency futures, are essentially impossible to explain. But, more recent work focusing on the microstructure of currency markets has suggested that exchange rate movements can be partially explained by the types of variables that market participants follow, such as order flow (for a summary see Lyons 1992).

The profitability of speculators may then give some insight into whether a group of specialist traders is able to predict changes in currency futures prices, and so exchange rates. To pre-empt our results, we find evidence that suggests speculators are profitable.

Over the years several papers have examined the profitability of speculators in futures markets. In an early contribution to the literature Houthakker (1957) examined profitability in corn, wheat and cotton markets using monthly positions data. Yoo and Maddala (1991) did likewise using several commodities and currencies. Both papers found that speculators tend to be profitable. Using a four-year sample of confidential daily data for several commodity and interest rate futures, Hartzmark (1987) found that hedgers make large and significant profits, while speculators made small and insignificant profits. This result, however, likely depended on a questionable assumption about the prices at which positions are opened and closed. Two recent papers have used the same data on speculators' currency futures positions that we use. Klitgaard and Weir (2004) provide a good overview of the general properties of the positions of speculators and hedgers in currency futures markets, but do not consider profitability. Wang (2004) suggests that currency speculators are profitable, but does not attempt to estimate profits.

In this paper, we make use of a long 10-year sample of weekly positions in currency futures markets and prices for individual futures contracts to calculate estimates of profitability. Using daily turnover volume and prices we are able to construct weighted average prices to proxy for intra-week trading prices. The data we use are described in Section 2 with the estimates of speculator profitability in Section 3.

We then examine two classes of explanations for speculators' profits in currency futures markets in Section 4. Hedgers, who have fundamental currency risk they want to offload, might pay speculators a premium in the form of a positive expected excess return for taking on their currency risk. There is some evidence this is the case. However, it is not possible to completely attribute profits to risk premia. An alternative explanation is that speculator profits derive from superior forecasting abilities. We consider one commonly used forecasting technique, the use of technical trading rules, or charting techniques. There is a large literature that documents the ability of these rules to generate hypothetical profits (for example Taylor 1992). A significant criticism of these findings is that they may be the result of data mining because the particular form of the trading rules can be selected ex post. The profitability of speculators and fact that their positions are broadly consistent with trading rules provides independent evidence for the success of trading rules.