The Research HUB: FX Primer, Pt 3
The primer for understanding and trading FX
This is Part 3 of the FX primer. Here is the initial breakdown of the 5 part series:
5-Part FX Primer Breakdown:
Part 1: FX - Resources, The Big Picture, Variables, Aggregating Knowledge, and Essential Tools.
Part 2: FX - Synthesizing Information from Part 1: Theory, Practice, Causal Mechanics vs. Regression Analysis.
Part 3: Delving into Historical Case Studies: The Importance of Studying History, Continuity vs. Discontinuity, and the Challenges of Backtesting in FX.
Part 4: Examining the Current Environment.
Part 5: Integrating Knowledge: Top-Down and Bottom-Up Analysis, Attribution Analysis, the Expectations vs. Actual Matrix, and Quantitative Models.
Be sure to read Part 1 here:
And Part 2 here:
We have broken down HOW to quantify the moving parts pertaining to FX. In this section, we will go through some case studies, and I will provide the principles that I personally use when conducting backtests and historical studies. I will also provide a list of resources that I use.
An initial example is the article I wrote on Argentina:
Let’s get into it!
We have covered many of the ideas for quantifying the moving parts pertaining to FX, but this only gets you so far. In the second article, I noted that you need to understand the GIP of a country, the balance of payments, and the impossible trinity. The difficulty that arises is that even with these three ideas, there can be many different combinations of them that move FX. Most of the time, you need to spend time reading history to ensure you are quantifying data points correctly.
On top of all of this, history is clear (theoretically) in retrospect. When you are operating under uncertainty in the present, you are in a constant state of analyzing the distribution of probabilities as they might occur.
When you look back on history, it's easy to fall into a deterministic mindset instead of a probabilistic one. This will be a key point to keep in mind because when you study history, you need to intentionally think about how probabilities and potential scenarios develop, as opposed to merging all data/ideas to the actual outcome that occurred.
The Importance of Studying History:
There are several principles I keep in mind when studying history, whether it's for FX or any other purpose.
There is no substitute for real experience, but one way you can offset a lack of experience is by studying history. Regardless of the amount of time you have been in markets, there will always be experiences you haven’t encountered. History can serve as a tool to navigate this.
Studying history frames the significance of data. It is very interesting to me that some quants will spend all day with various datasets and literally not know what was causing the data to change during a specific period of time. I always want to know the WHY behind data during specific periods because this informs HOW I will categorize and quantify that period.
The final point I will make is that studying history is one of the best tools for redundancy planning, scenario analysis, and analyzing the present.
To be resilient you have to think preemptively
I wrote an entire article on this idea:
Continuity vs. Discontinuity:
On a more technical note, any time I am backtesting or thinking about history, I always consider continuity and discontinuity in scenarios. Many times, phrases such as “this time is different” or “this time is not different” are more about clickbait and reductionism than actual analysis.
There are ALWAYS differences, and there are ALWAYS similarities. It's more about identifying causal factors that are similar to the past so that you can act in a statistically significant manner. Then, you account for discontinuities so that you correctly employ a priori thinking where it is needed.
The Challenges of Backtesting in FX:
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