EXCHANGE-TRADED CURRENCY FUNDS AND INTERNATIONAL DIVERSIFICATION

1 | P a g e

1.0 Overview of Exchange-Traded Currency Funds (ETCs)

1.1 Definition and structure of currency ETFs

ETCs can be considered as collective investment schemes and provide foreign currency markets exposure

by ETF or other exchange-traded products. Abell and Kruger (2013) provide for solid measures of

analyzing exchange rate exposure levels associated with a given portfolio, whereby the portfolio manager

should appreciate —and incorporate— currency risk in investment decisions. Usually these tracks buy or

sell according to performance of specific currencies or indices. This way investors can get the targeted

exposure to currencies actually without being involved in forex trade. ETCs provides the investors with such

benefits as diversity, liquidity, and access to price movement. Diversifying the portfolios of the investor

allows the addition of currencies in different representation which in turn lowers the overall risk element

(Mizrach, 2010). In addition to that, the ETCs are traded on the major central exchanges and investors gain

liquidity and transparency from this relative to the cross border tracking of the major currencies

(Schoenberger, 2015). Besides, the accessibility and simplicity of ETCs dealings creates trading chances

to a great host of investors like individual retailers as well as institutions (Barnhart, 2013). On the contrary,

Exchange Traded Commodities are focused on tracking the progress of specific currencies or groups of

currencies but this might not always result to the perfect correlation between the derivatives and the

underlying currency because of the existence of factors like management fees and transaction costs

(Zhang, 2012). Consequently, investors thus should be in making a rigorous research and due diligence

before investing in ETCs because it is very important to them in achieving their investment objective and

stabilizing their risk-tolerance. In general ETCs introduce a new instrument that gives investors an

opportunity for convenient and efficient exposure to the foreign exchange markets as well as other assets

which, however, should be monitored and analyzed carefully to minimize possible risks involved.

2 | P a g e

1.2 Growth and popularity of currency ETFs

ETFs that deal with foreign currency are like traditional ETFs, only that the shares are listed by exchanges

and the assets are residuals from a currency or any currency-related asset. Bilyk (2017) or Akram et al. ,

(2008) are the most relevant research that already anticipate this – monitoring the arbitrage opportunities in

the foreign exchange market over the long run and detect significant microstructures in the human

activities. Exchange traded funds go for physical cash notes, which are options of contracts that are

futuristic or any other derivative instruments and they actually guide this to mirror the movement of a

particular currency or currency index. Thanks to the apparatus of currency ETFs investments the possibility

of getting access to currency markets without even trading comploting with foreign exchange market is

opened. According to Abell and Krueger (2013), in an investment situation currency risk has to be tackled

on, and the reasons as to why Currency ETFs have become quite essential in minimizing the currency risk

that the portfolio managers is facing are also well spelt out. Investors in foreign currency ETFs often do so

to ensure they are well-positioned against currency risks or to participate in deals that depend on exchange

rate movements, which again depends on whether their aim is to reduce currency risks or to make gains

from resulting exchange rate changes. Currency ETFs bring many benefits to the table besides the

diversification of portfolios with less hassle and lower-cost involvement of global currency markets for

investors. The structure of currency-ETFs provides ample liquidity, that is why one can buy and sell them

very easy, and that’s why the investors can enter or mercantile their position as they want. According to

Bekaart and Hodrick (2009), two academicians, the research that they have done empirically is on the

determinants of currency risk premia, and they noted that currency risks may arise in different ways and

some exciting investment strategies can be embraced if currency ETFs are included in the picture.

3 | P a g e

1.3 Benefits and risks of currency investing

The large expansion and market acceptance of currency ETFs can be credited to investors' increasingly

developing appetite for putting funds into various asset classes and hedging currency risks. Alexeev and

Dungey (2015) by offering the descriptive approach of how currency risk can be priced strongly explain the

pricing dynamics along with the other driving factors of the currency returns. Currency ETFs actually serve

as a simple and low-cost option for investors to pursue investment in a multitude of currencies. Hence,

these vehicles enable them to hedge against fluctuations in currency or exploit emerging currency trends.

According to Abell and Krueger (2013), investors should therefore factor in currency exchange rates when

analyzing portfolios as it becomes critical and emphasizes that it should be a considered element when

making investment decisions. Rather than having to invest in a whole currency as a currency instrument

would do, investing in these vehicles offers the flexibility and liquidity which allows investors to vary their

currency exposure depending on their risk preferences and investment goalsIn addition to that, Akram,

Rime, & Sarno (2008) investigated the arbitrage possibilities in foreign currency markets and their findings

on this microstructure of currency market trading contributed significantly. Tracking specific pairs of

currencies or indexes, ETFs of currencies are very instrumental tools that provide investors with

transparent and liquid exposure to currency markets that in turn favor efficient price discovery and trade

execution. The accessibility of currency ETFs is also a key aspect as these investments can be traded on

stock exchanges just like equity funds, therefore allowing investors to seamlessly incorporate currency

strategies into their market investment portfolios.

1.4 Major currency ETFs and their compositions

To start with, the ETFs on major currencies are very diverse when it comes to investor requirements, as

they focus on either a single currency fund, a currency pair, or a broad index comprising multiple

currencies. Becker and Browning (2013) have also provided detailed information on currency carry trades

4 | P a g e

from a portfolio perspective, so investors or readers can have a clear view of currency trading strategies

with a diversified portfolio. The authors, Bekaert and Panayotov (2020) underline the different sorts of

dynamics in the carry trade such as outstanding and bad carry and offer the insights for currency investors

bringing up the topic of currency trading strategies which consequently disclose the complexity of currency

trading strategies. These EFTs, in turn, will cover the key currencies such as the US dollar, euro, and yen,

and this will enable investors to gain from movements of their currencies as compared to others. In addition

to the ETFs that specialize in currency strategy undertaking, e. g. currency carry trades or hedging

strategies, the investors have the flexibility to decide if they want to adjust their approaches to currency risk

management or if they want to benefit from the currency market opportunities. Investors can use currency

ETFs in order to singularly or collectively track one or several currencies or currency pairs, which will in turn

enable investors to purely focus on certain currency movements or performance of currency pairs.

Furthermore, the broad-based index of currencies allows investors to view the performance of the whole

currency market and on the other hand, such investors can diversify their investment across other

currencies. In this way, currency ETFs grant investors to reach authentication and clarity in the currency

exchange procedures, enabling them to adapt their currency strategies to their overall investment

portfolios. Whether you want to hedge foreign currency exposure, exploit forex volatility, or manage the

currency risk, major currency ETFs provide a vast collection of tools that enable traders to act in the

dynamic and ever-changing underlying markets of currencies.

2.0 Currency Exposure and International Portfolio Diversification

2.1 Reasons for currency exposure in portfolios

The covering currency is a broader and woolly term that captures all the repercussions from such aspects

as trade on the global scale; offshore investments; and country economy in general in a broad manner. Be

it Bhansali (2007) who highlights connections between volatility and foreign exchange markets, or the

5 | P a g e

further development of some carry trade practices, stability in currency markets is the likely result. Volatility

– which coincidentally is the main interpretation element of these markets – could kill the fortune of all the

traders when not properly managed and is also at the foundation of a great number of investment

strategies the director mentions. Byrne, Ibrahim, and Sakemoto state that currencies involved in exchange

rate carry trade programs are chosen carefully and point out the significance of the foreign exchange risk in

investment decisions. It is that very point which draws a clear relationship between currency movements

and investment returns while demonstrating that currencies can change their value and therefore affect the

reserves of those who rely on the carry trade strategy. A currency risk exposure is a dominant factor that

investors must fully grasp and attest on, as reported in the case study on CURCURU, VEGA and HÖEK

(2010), for a successful management of the portfolios to take place. They claim that highest gains on

investment performance and portfolio success may get missed out when travellers shift their domicile and

get access to foreign ideology at the expense of sharing cultures and traditions through exchange of

information. The working knowledge of supporting this case departure from currency exposure wise may

make the investment decision- making process in that matter go uphill, to the detriment of optimality, and

exposing the portfolio to baseless risk. De Zwart et al. (2009) further works into the subject related to the

new market of currencies, demonstrating that even basic and technical information bear economic

meaning, and investors would ignore different currency pair at their own peril for the sake of diversification.

This view has it that if the markets are to be understood and currency risks are properly managed, then

market participants have to have a plethora of knowledge about the technical as well as the fundamental

causes. The brunt of the work lies in suggesting that this is anything but a walk in the park. At the end, the

hedging of currency portfolios is an issue with both pros and cons because there are particular conditions

such as the market volatility, the position of carry trade and the economy which have effects on it. The

takeover most particularly the one that is market- related should be observed keenly before coming up with

the investment decision. This leads to improved situations to optimize investment output because it helps

6 | P a g e

investors with their decisions to avoid a loss as well as improve the total or net return that investors can

attain from their investment in that particular asset class.

2.2 Hedging currency risk versus active investing

In general, the investors need to eliminate or manage these risks which include currency risk related to

whether to hedge risks and strategic choose the enter assets. According to the authors of the article

"Mechanics Behind and Fundamentals of the Carry Trade" Burnside et al. , "peso problems" cannot be the

only reason for the carry trades returns, formulating the opinion that the currency investing is not a dead-

end safe. What their studies showed is that these capital flows have a potential of dragging the exchange

rates for carry traders many times and also warned that sense of risk is important. Clarida, Davis and

Pedersen (2009) are involved in active currency management techniques that go beyond simple regression

models. It is thus a challenging venture in the near future to master the skill of analyzing currency trading.

They display the kind of information that the markets values the most: the market peculiarities and all the

potential scenarios that the currencies' movements may bias the forecast. Just as pointed out by

Brunnermeier, Nagel, and Pedersen (2009) that along currency crashes, carry trades also had been

tackled, it only shows the vast risks around active currency investment and significant loss could be

expected. They have disclosed this by showing how speculators who are the most active category of

foreign exchange traders are the most likely to incur losses during such crises. This instability could trickle

down to the general economy. Cullen, Gentes and Shawky (2012) sought to explain the use of various

derivatives (a). g. side of the market (by means of the fluctuation of currencies via FX futures and options)

from multinational corporations as well. Overall the surveys document that, being bold and proactive in

currency risk – although may be lucrative – it still has its risk profile and downside. Those risks assertions

invoke a sober reflection on the essence of well thought out risk management strategies and a noticeable

7 | P a g e

trend among investors towards rightly identifying the opportunities and the inherent issues around currency

market trading decisions.

2.3 Correlation of currencies with other assets

It is necessary to learn about the associated side effects of currencies that serve in rating of other assets

for the portfolio diversification. Bhansali, in the face of the exposure to volatility of fiat currencies in the year

2007, sets the tone for working of this theory as the backbone of not just carry trade strategies but also for

others. Over turbulence another point voter makes the direction saying this stock market obviously has the

degree of interlinkage and dependence that determines the level of currencies’ reciprocity. It is recognized

that cross-sectional variables, as emphasized by Byrne et al. (2019),play a part in the expose of carry

trade, which also may corroborate the theory that asset correlation is responsible partly for the carry trade’s

position in a currency portfolio. It is argued that there is feedback between occurrences in for instance the

trade deficit and shifts in which are other domestic assets that include market sentiment and macro-

economic conditions with the change of one another. Moreover, she claims that in a free market that is still

developing its economy, the fundamental information may have another economic value compared to the

developed information. She also states that the correlations of other assets with each other may be far

different from where the information is complete. The authors are led to a conclusion that the reason for the

interconnection of currencies and other assets may not simply be due to the fact that the pairs are

currencies only. In addition, Looking through the research conducted by Curcuru et al. (2010) reported

that a correct assessment of foreign currency exposure is imperative for accurate analysis of its correlation

with other portfolio positions. Accounting for currency positions as Curcuru et al made, it becomes vital as

part of the portfolio evaluation of currency effects on the success level of that portfolio and into an asset

class diversification. The evidence from these studies clearly illustrates how sensitive the values of one

asset are to the state of other assets as well as to where they are traded. Hence, the investors should

8 | P a g e

return to the old school principle no matter how complex the world becomes - carefully consider all possible

currency correlations before making investment decisions.

2.4 Role in overall portfolio risk management

Along with the fund allocation, currency exposure plays a major role in the cover all the portfolio segment

strategies risk analysis. The authors of the article " Risks of Active Investing in Currivecies" by Burnside et

al. (2011) have exposed a social problem emerging out of active investments in currivecies. From this

point of view, the significance of understandning candduting the currency effectvness management

becomes clear. Furthermore studies have the same issue that volatilities are the fundamental of currencies

markets which means having a bad effect on speculators who are dealing with the currencies as well. With

regard to a currency carry trade framework that is discussed by Clarida et al. (2009) studying various these

regimes will become critical in managing risks that are embedded in the currency portfolios. A portfolio

manager will learn about various political regimes which are combined, investors will acquire insights into

the impact on the constant changes in markets for currency for the portfolio risk management. Finally,

hepler (2012) exposes the application of currency derivatives by the large corporations that seek to hedge

currency fluctuations and, thereby, identifies the practical currency risk management solution. The article

not only will inform more regarding the dynamics of currency risk hedging arising on the role of currency but

also will show that company’s values are able to get protection from currency fluctuation. Therefore, the

companies which are subject to currency exposure is no longer the critical factor in the deterioration of such

companies financial performance for derivatives can already be applied in this specific transaction. The

behavioral aspect of risk management in forex, as Curcuru et al. (2010) observed, is distinct in the ness

between the decision-making and the risk-aversion measures. They maintain that members of a market

also tend to use both the historical as well as fundamental determinants to assess the risk abetting their

decisions. Hence, these studies quite clearly suggest that the next step will be for currency management

9 | P a g e

toward the final goal of risk management spanning the whole processes of risk management. Through the

classifying of the valuations to currencies and applying a successful risk assessment method, a capitalist

can avoid currency changes’ effect on his portfolio and obtaining its highest potential gain and long-term

prosperity.

3.0 Macroeconomic Factors Influencing Currency ETF Performance

3.1 Interest rate differentials and carry trades

Domestic currency exchange traded funds have also been very helpful in how they have been traded

based on interest rate differentials. This is especially true for carry trades. The situation portrayed by Engel

(2016), that currency risk premiums are governed by exchange rates and interbank rates differences, may

be further validated by interest rates premia being part of the picture as well. Thus, Engel elucidates the

connection between interest rate disparities and the way currency market copes with them. Such

dissimilarity in interest rates is often behind currency movements. This extent of greater volatility may also

lead to the ETF’s performance being diversified or depend on the specified basket of ETF. Drybnskikh

(2014) shows risk analysis in terms of trader's carry currency that he/she chooses, under condition where

developed market and EME currencies go in different values. Through the help of empirical research,

Dobrynskikh tries to provide the explanation of how the different factors like rates of interest differential

impact on the carry trade strategies and subsequently affect the performance in the currency market; this is

pursuing the object of coming up with the solutions for the problematic and complex nature of trading. Apart

from this, Farhi et al. (2015) use another example that demonstrates the probability of a falling ETF

performance during those years with the two highs in the plots being the interest rate differentials and the

volatility or the currency market. In this research, the first point is specializing in the direct effect of risk

distortion enlarging market downturns while the second focus is implying that ETF traders should pay

attention to the fact. For example, Erb, Harvey, and Viskanta (1999) recommend such a valuation metric as

10 | P a g e

cross-rate correlation which represents similar risk in the local currency countries and may be helpful in

further decision making regarding those currencies. Scholars Erb and his colleagues significantly

underscoreless investors on how the current interest rate differentials in emerging market bonds arouses

concerns, and with this similar audience who may perhaps would use currency exchange traded funds

(ETFs) beyond their portfolio decision. In a way, such experimental data should be deemed likewise

valuable as the impact of currency rates and their investment strategies in the foreign exchange markets is

portrayed almost simultaneously as these may be crucial in the investing of currency.

3.2 Economic growth and trade balance dynamics

Another disturbing factor for these funds is the macroseconomic imbalances here economic growth rates

and trading balances are taken into consideration. According to Ferarin and Ferraris (2006), country risks

consist of the very crucial elements in stock market performance. They hold the belief that the investor

sentiment reflects on the regions' economic growth of developing countries and therefore impacts

exchange rates. It is a research which pinpoints the level of vulnerability of economic growth and market

sentiment to the success of currency exchange investments, destiny of which depends only on positive

market growth prognosis, uplifting currency exchange investment returns. Dziuda, Rutkowska and Wang

(2012) tell that the problem of asymmetric information and home bias hinders the process of portfolio

management decisions; the scale of economic growth expectations is used by managers to decide where

to put money, including in currency ETFs. Dziuda and Ish discuss in depth how dynamics of the economy

influence investor selections, with mainstream preference shifting to currencies which are then actively

channeled to diverse assets including ETFs (Exchange Traded Funds). Taking it one step further, Farhi et

al. (2015), propose an interdependence between economic shocks as well as the currency market

crashes, which are likely to raise the level of currency market volatility known to worsen the outperformance

of ETFs. Such analysis implies that the currency markets are experiencing unstable situations due to the

11 | P a g e

confusions on account of current account and the case that the investors in the EFT need to take into

account the economic shocks when they are evaluating currency investments. On the other hand, Engel

(2016) also acknowledges the fact that the exchange rate and economic fundamentals play a role in the

returns of ETFs, so it is likely they increase the risk-premium and the ETF value in return. The model by

Engel in support of the theoretical framework shows how the uncertainties related to macroeconomic

growth may interact with the currency exchange markets and thus result in variations in the performance of

currency ETFs. The aggregate finding from the studies clearly indicates the multidimensional relationship

building through the interplay of the trio, economic growth, trade balance, and currency investment and

argues that the relationship between the trio is not without any interdependence and therefore,

understanding the linkage is the key to investing in a currency.

3.3 Central bank policies and currency interventions

Central bank’s policy decisions, which are based on their interventions in currency, are the most significant

factors in currency ETF trade activity volatility. Dobrynskikh (2014) reveals contingencies of the currency

carry trade basket, which have an influence on the central bank policies and forex market situation is

determined by it. Therefore, country by country different currency carry trade risks are created. Ilya

Dobrynsky supplies such analysis and showing what tools central banks are using and these are also the

factors that do directly affect currency ETFs. Farhi et al. (2015) believe that there might be an increased

likelihood of a currency market crash brought about by the coordination dissemination of a monetary policy

intervention into the market as it is a known fact that the currency market is fast-paced and depends largely

on market forces and currency movements for investment decisions. Another important point, which has

been discussed by Erb et al. (1999), is that the currency of the country targeted by intervention may

become the object of increased investment if governments use monetary policy tools such as repurchasing

foreign bonds. Throughout the article, Erb empathically brings to light the one-directional connection

12 | P a g e

between how central banks operate, the investors’ opinion about how the currency price is expected to

evolve and where investors place their money. They bring out the influence of investors to consider these

aspects when making investments which can be either good or bad for the society and the individuals

involved. Engel (2016) contemplates over how the amount of their wages goes on to influence what their

range of the currency risk premium and the monetary policy of the central bank is, thereby making them

primary players in the performance of their country’s Currency ETF. Engel's article is able to reveal the

development of the policy that may cause the differences in the appeal of currency Exchange Traded

Funds. Therefore their yields are not correlated directly with policy. Alongside these information, the

evidences show us that the strength of central bank policies and currency markets on currency ETF

performance is of the highest. Further, central bank's decisions must therefore be reviewed and the effects

scrutinized, which is not only a case of economic but also political events. Therefore, political aspects

should be considered too, so that political decisions, as well as the ones on the economy, can be taken

informed.

3.4 Political and geopolitical events' impact

Political events as well as geopolitical news represent the main drivers of the currency ETFs which move

them up or down in value. Hence, the economic performance of the country being traded-off is a key factor

to be considered before the commodities are assigned a value. Ferreira, and Ferreira, (2006) divide the

country effects into two categories, namely political instability which is linked to the economical instability

due to the fact that the mushrooms in the direction of the negative economics influences investors

confidence and confidence in the currencies match zero. According to the source of Dziuda and Mondria

(2012), it is brought about an imbalance in the decision making process of the fund manager due to home

bias and information asymmetry. This is more likely to be the case in the situation when the macro-

economic events are witnessed across the world, for example, exchange rates and monetary policy.

13 | P a g e

Dziuda and Mondria prove that this is connected with a myth accounting for the sheer doctrine of ideal

management of funds through passive techniques which in turn gives evidently impact the mechanism of

decision-making. On the other hand, their point is that everything is made clear by the end of springing

uncertainty situation and therefore businesses need investment according to the set rules and regulations.

On the same note, Farhi et al. (2015) explain political concerns are these factors that can trigger downfall of

currency market which will cause market volatility and hence, have a great effect on ETF performance.

Besides that there Dobrynskikh (2014) sees view: on a currency that carry trades take place the risks must

be investigated with follow up measures in mind. Meanwhile political instability rises that giving currency

risks the title of visible trend. Experimental-based observation is the central point of his arguments about

political events and the risk factor ―uncertainty‖ that may result in the obstacle of the market units due to the

activity of ETF currency funds which may also have an effect on the performance of these funds. As a

result of this, the role of two factors, namely political and geopolitical, has become the two most recognized

cases, which stir the contribution to FX ETF. As a result, assume the role of currency investor no hasty

without first and foremost a thorough research of these flows and factors.

4.0 Tactical Allocation Strategies with Currency ETFs

4.1 Momentum and trend-following strategies in currencies

Among the most prominent and important elements of the configuring tactics applied in currency ETFs’

mostly two are price momentum and trends’ following. As give by Han, et. al (2021), the currency

momentum is analyzed from the viewpoint of the risk factors of the carry trade, suggesting that the path

followed by currencies matters. Dewravel Froot and Suresh Ramadorai (2005) mention currency returns

and flows of institutional investors and they argue that momentum strategies can be applied for trends

generated by investor sentiment and flows. Through exploring the interconnection of fiat currency returns

and institutional flows (which illustrate the effect of market trends on investor behavior), Froot and

14 | P a g e

Ramadorai are making it clear that momentum strategies can work with this behavior. On the other hand, it

is put forward by Fong (2010) a stochastic volatility model for currency carry trade, in which momentum is

highlighted in valuation optimization. One can witness that Gregory Fong gives the emphasis on the role of

momentum through which a profitability of currency carry trades is affected, refuting a tactical decision

when using currency ETFs. Similarly, Geweke and Zhou (1996) are involved in the measurement of the

reliability of the pricing error of the arbitrage pricing theory and show that momentum strategies can profit

from the inaccuracies foreign currency market. The authors Geweke and Zhou, thus demonstrated by their

analysis, suggested the applicability of momentum strategies, the potential to which they could use for

exploiting pricing inefficiencies in the global currency market, implying their relevance in the allocation of

currency ETFs with regard to tactical asset management. It can be extremely useful to pursue these

pathways so as to remain on the positive side of the market performance.

4.2 Currency carry trade and yield enhancement

Carry trade regimes are just about the essence of amount of position and statement of outcome, but all this

goes without saying that they are certainly the essence to income over tonnage. Wavelet interaction

analysis is the key proposition that should be considered by Guo, Kurov and Wolfe (2018) when studying

the use of exchange rates and carry trades. In this respect, crowdfunding has shown to be the way to

diversify among distinct budget loaning and borrowing ways. Nevertheless, in this, the authors illustrate that

the currency strategy provides leverage to generate higher returns through those with differentials in the

two countries, so that the CTA instead works as tactical instrument of asset allocation by using CETFs. On

the other hand, Fong (2010) argues that we need a stochastic volatility model to cope with the carry trades

strategy (risk of returns originating from them). Fong (2002) stochastic volatility approach and which aims in

demonstrating the patterns in currency dynamic by which the carry trade technique can obtain enhanced

returns. Striking the balance between the size of the allocation and the portfolio nature is the ultimate goal

15 | P a g e

of this step which will be a essential basis for the achievement of strategic goals. However, what Gromb

and Vayanos (2010) have done can be contrasted with this in the sense that they are referencing arbitrage

as their central object of inquiry. This term is a market operation meant to scoop some profits through

taking advantage of the very specific inefficiencies or prices accordingly of currencies. The fund-raising

scope of the physical ETFs is enlarged when looking at currency ETFs. Furthermore, Fratscher (2009)

article describes the way in which the international exchange rates reacted during the financial crisis and

how investors are able to use these dual benefits and market fluctuations. Frascher cleverly points out that

a carry trade tactic under currency portfolio still would be effective even in unstable economic times, and

such kind of a tactic may become profitable as the returns here is beyond reach for the risk-averse

investors since currency ETFs have had outstanding performance last years. Dualistically, studies

exploring the issues on currency carry trade strategy and the investments in the currency ETFs identify that

currency-hedged equity ETFs perform relatively well as they aided in the return maximization and

minimized the portfolio risk.

4.3 Mean reversion and currency valuation models

First and foremost, strategic allocation of currency ETFs should be done with consideration of the mean

reversion and discounted cash flow analysis of currencies. In line with academic research presented by

Griffin and Stulz (2001) the oil reversion strategy might be proved to be applicable in forex. A work that they

do shows that in concert with mean reversion strategies – which are popularly seen in the stock market,

that the foreign exchange market can also make prospective readjustments to the short-term deviations

which occur from the long-run average exchange values. Froot and Ramadorai (2005) study currency

returns together with intrinsic value proposing the fact that the mean reversion strategies are efficient

mainly because of value deviations. Froot and Ramadorai argue that, through tracking the course of

currency returns and their alignments with intrinsic value, mean reversion techniques can help investors to

16 | P a g e

identify currencies that they discover to be price lower than their real intrinsic value and gain profits by their

recovering movements. Furthermore, the focus of the literature of the authors Geweke and Zhou (1996)

effort is to solve the pricing errors of the arbitrage pricing theory by considering a new kind of mean

reversion strategy that may benefit from the FX mispricing. The latter mention its applicability in terms of

gaining benefits from mispricing errors and historical model difference which allows some advantage in the

forex market. Besides that, Han et. al. (2021) also brings an understanding of carry trade from currency

momentum rationale factors risk factors. It is the cause of the mean reversion strategy which may

simultaneously act alongside the momentum strategy to benefit the tactical investments by the currency

ETFs. The approach of Han et al is a quantitative one, considering previously deployed ETF trends coupled

with embedded mean reversion signals.

4.4 Integrating currencies into multi-asset class portfolios

Putting currencies into a multi-asset class portfolio requires a complete cognition of currency movements

and their symbiotic relationship with subsequent asset classes. Fratscher (2009) points to the role of global

exchange rate fluctuations during the financial crisis in a bid to underscore the need for considering of

currency effects when investing in multi-asset class portfolios when markets are in turmoil. His research

however point to a currency dynamics which heavily influence portfolio performance in both the good and

bad times, especially when the markets are generally volatile. Guo et al. (2018) have effect of carry-trade

strategies for exchange rates on the basis of wavelet analysis, the results of which show that currency

strategies can have good diversification effect on the portfolios with multi-asset classes and can also

increase the risk-adjusted returns. Guo and colleagues suggest that currency strategies could be a great

way to broaden the spectrum of portfolio diversification and hedge against risks which flow from

international markets. Also, Gromb and Vayanos in 2010 outline the confines of arbitrage agreeing that by

combining currency and other available strategies can redeem opportunity gaps across asset classes.

17 | P a g e

These research questions to use currencies strategies which take advantage of out-of-market exchange

rates and inefficiencies in global capital markets so portfolios of multiple asset classes become more

efficient. Moreover, Han et al. (2021) also present some brief information about currency momentum

emanating from trade risk factors, implying that investment in hedge currencies seems promising for multi-

asset class portfolio with currency ETF. The approaches which will be mentioned in the work could also

give more sturdyness to some investors in the currency markert by beneficiating from the short-run market

trends.

5.0 Regulatory and Operational Considerations for Currency ETFs

5.1 Trading mechanisms and liquidity of ETFs

The introduction of currencies-ETFs into the market environment altered the way these products are

regulates and worked and created the problem of choosing a trading method and liquidity. The

Researchers Haynes, Roberts and Yao (2021) also can't disregard the fact that risk related to the currency

exchange rates and related premiums is one of the most important issues in the development of currency

exchange-traded funds, and therefore they consider liquidity as a major factor. The study investigates

liquidity with circulation being the primary factor of tactical maneuver and lessening of the exchange

premiums risk therefore it is noted that the currencies, ETFs platform is the best. Hossfeld and MacDonald

(2015) study the influence of such demand for liquidity and the safe haven currencies that this can push

towards, something which can become significant in the case of funding currency. From the presented

step the management of liquidity becomes obvious with regard to Exchange Traded Funds. First in all,

Huang and Zheng in (2020) examine cross-sectional return dispersion as well as active currency

management, which, to some extent, have liquidity constraints that could hamper the efficiency and

success rates of active currency strategies. This technique deserves as a true reflection of liquidity plays an

important role in successful currency management, which ultimately is necessary for currency investments,

18 | P a g e

since the absence of liquidity may not only face traders with timing decision, but also dramatically decrease

effectiveness of their trading strategies. Heckerman(1972) also presents portfolio composition and him as

well as other’s activity in open markets works these mechanisms in mechanism in ETF market making

asset valuations and liquidity provision. By building in this way, she firstly explores the supply imbalance

mechanism and the way in which it is linked to asset pricing dynamics' developments, then points out the

regulatory considerations' impact on liquidity provision along with benefits market efficiency offers including

those for currency ETFs. These two are a must-have in the process of making the ETF market for

currency complete and function better.

5.2 Tax implications and treatment of currency

Investors in the currency ETF, however, will need to deal with taxes and protocols of accounting regarding

this. Contemporary Investment: The implication of the social cost of inefficient investment is explained by

Hassan and Mertens in their work (2017). Consequently, it is also proposed that the taxes levied should be

made as tax-efficient as possible to achieve the lowest overall cost for investment and as such, the tax rate

should be lowered. Because of this, their work seems to be focused on the maximization of efficiency via

reduced currency ETFs funds associated cost. However, it is a good practice to invest having in mind that

the income tax implications should be consulted. Through the works of Haynes et al. (2021) focus is laid

on the resources, time, and effort that may be necessary and capital control by the country on the foreign

funds. In the study that Haynes et. al write, we can learn the role taxing plays in currency ETFs.

Translation into terms: the opportunities which are based on time strategies, when the profits are benefit tax

and have ETF currency returns are essential. Huang and Zheng list two issues that result from returns

across all countries and active management. They recommend that some taxes should be taken into

account because of the fact that they affect decisions that will be made by investors regarding foreign

exchange. One of their key findings indicates that tax issues may alter the way active currency

19 | P a g e

management strategies are implemented and accordingly, a tax effective framework becomes the

investment justification while trading. Besides that, Heckerman's (1972) opinions on portfolio selection and

the asset prices prooving that, taxes are also one way of determining the investments an individual does,

such as how the investor structures his portfolio and allocates the assets. Heckerman's opinions view the

broad effects that tax menace has on investment strategy of the investors as well as highlighting the need

for investors to make a point to ensure that they tie up the tax considerations to the investment process

whenever they want to acquire a currency ETF.

5.3 Custody and safekeeping of currency holdings

The operational significance of carefully performing the function of the center of custody and vaulting

facilities in the structure of asset holding of currency ETFs is highlighted by experts as being a crucial

aspect. The statement of Rennie Hassant and Klod Bangert Mertens (2017) present the proof that social

cost of greedy investment exists, which emphasizes the need of custodial structures in order to lower the

risk. Although their work mainly points to the necessity of having high governance models of custody to

guarantee that investor's funds are not misused/lost/or stolen, they strongly argue for the protection of

investor's currency within ETFs and the minimization of the chances of their money getting loose or

misused/lost/or stolen. It has been demonstrated that the existence of the custodian safeguards the quality

and safety of any asset in ETFs. Another element is safety of the investors and the authors (Haynes et al.

2021) emphasize that the money of the investors must be stored in strong reliant stewardship. Another

point of research found is that the service has a purpose of the security structure which provides a trustable

and reliable place for the investors’ assets to be clear of all operational risks as well as other possible

hazards. Moreover, Hossfeld & Macdonald (2015) conduct a thresholds analysis between the safe haven

currencies and the mortage collateral and conclude that bond safekeeping can cause ETF functional cost

to increase. As such, it is the additional analysis performed by Hossfeld and MacDonald of the relationship

20 | P a g e

between custody risks and currency funds’ cost which only stresses the fact about the buiseneses case at

hand since it shows the positive effect on performance and minimisation of risk. Fundamentally, there are

academics experimenting on the role of custody in ETF units in tracking the performance of the reference

asset while simultaneously mitigating the risk of fraud and theft. Consequently, these operations are vital in

preserving the integrity and security of assets in the funds.

5.4 Counterparty risk and fund structural considerations