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Subject 9. Short-term forecasting tools

Technical analysis is a popular trading tool for many FX market participants.

There are different forms of technical trading rules. Some are designed to identify market trends and reversals, while others are designed to identify overbought or oversold conditions, relative strength, and support and resistance levels.

Many studies concluded that a variety of trend-following trading rules would have generated significant profits for the period between 1970 to 1995 had such models been actively followed. However, these rules have not fared as well since 1995 because persistent and pronounced exchange rate swings are not occurring as often as they did in the past.

Although technical analysis cannot generate above-average return, it may still be a useful tool for controlling risk.

A strong positive, contemporaneous relationship exists between the trend in order flow, sentiment and positioning indicators over short period of time. However, the evidence is mixed whether such indicators can help predict the future direction of exchange rates.

Practice Question 1

If properly deployed, technical trading rules can help FX fund managers:

I. the risk of excessive positions.
II. the crash risks of carry trades.

A. I only
B. II only
C. I and II

Correct Answer: C

Such rules can help investors avoid taking extreme contrarian positions, and keep investors from leaning too heavily the wrong way when carry trade unwinds are occurring.

Practice Question 2

Which statement is true regarding technical analysis in the FX market?

A. Changes in net speculative positions usually lead changes in exchange rates.
B. Risk reversals are capable of confirming an exchange rate's trend.
C. Lagged order flow data can predict the short-term path that exchange rates will take, as most investors don't have access to such data.

Correct Answer: B

A is wrong. The size and trend in reported net speculative positions are not useful for currency forecasting purposes.

B is correct. However, risk reversals cannot predict changes in exchange rates.

C. Most studies find only weak predictive power from such order flow data.

Practice Question 3

Numerous academic studies concluded that many trending following trading rule, such as moving average crossover rules and filter rules, would NOT have generated significant profits had such models been actively followed during the period of ______.

A. 1970 - 1980.
B. 1980 - 1990.
C. 2000 - 2010.

Correct Answer: C

Practice Question 4

A novel experiment conducted by Curcio and Goodhart in 1992 concluded that technical analysis:

A. can boost average returns without controlling risk.
B. is useful to manage downside risk without contributing to above-average total return performance.
C. is prone to significant downside risk.

Correct Answer: B

Technical trading rules can be useful to investors for controlling downside risk, even if such trading rules fail to boost long-run total returns.

Practice Question 5

Order flow, sentiment and positioning indicators can:

A. predict the future direction of exchange rates on a short-term basis.
B. predict the future direction of exchange rates on a medium to long-term basis.
C. not be relied on to predict the future direction of exchange rates even on a short-term basis.

Correct Answer: C

Practice Question 6

A risk reversal can reveal or indicate ______ in the FX market.

A. dealer order flow information
B. sentiment
C. net speculative positions

Correct Answer: B

Study notes from a previous year's CFA exam:

9. Short-term forecasting tools