Optimal Portfolio Based on Hourly Trading in Foreign Exchange: Empirical Study on Five Major Currency Pairs (February 2010 April 2010)

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1 Optimal Portfolio Based on Hourly Trading in Foreign Exchange: Empirical Study on Five Major Currency Pairs (February 2010 April 2010) By: Martin Ariane Wibisana Undergraduate Program School of Business and Management Institut Teknologi Bandung 2010

2 APPROVAL PAGE Optimal Portfolio Based on Hourly Trading in Foreign Exchange: Empirical Study on Five Major Currency Pairs (February 2010 April 2010) By Martin Ariane Wibisana A Final Project in Partial Fulfillment of the Requirement for the Degree of Bachelor of Management Undergraduate Program of Management Study School of Business and Management Institut Teknologi Bandung August 26, 2010 Approved By Ir. Achmad Herlanto Anggono, MBA NIP:

3 ABSTRACT The investment world is full of uncertainty. Volatility of the asset is such a double-sided sword for every investor. In one side, investor could make a huge profit by utilizing the volatility; in other side they could loss of money because of it. Foreign exchange (forex) market has become one of the most popular investment instruments because of its volatility. This market has the highest volatility compared to another market. With this condition of market, the forex investors are accused to be observant in seeing opportunities by utilizing the market volatility. They have to be able to manage the risk effectively without losing any profit. This paper will try to find the way to manage the risk and return in hourly forex trading by using Markowitz modern portfolio and value at risk (VaR) as a consideration of the risk limitation of the portfolio and evaluate whether the portfolio is efficient enough according to the comparison of its return to its risk. The object of this research is the five most traded exchange currency pairs, which are Australian Dollar/US Dollar (AUD/USD), Euro/US Dollar (EUR/USD), Great Britain Pound Sterling/US Dollar (GBP), Swiss Franc/US Dollar (CHF/USD), and Japanese Yen/US Dollar (JPY/USD). The hourly price data of these currency pairs are obtained during the three months of internship period (February 2010 April 2010) in Valbury Asia Futures. Key words: forex, currency, forex portfolio, value at risk ii

4 ABSTRAK Dunia investas adalah duniai yang penuh dengan ketidakpastian. Volatilitas dari sebuah perubahan nilai asset dalam dunia investasi seperti pedang bermata dua untuk setiap investor. Di satu sisi, investor bisa membuat keuntungan besar dengan memanfaatkan volatilitas; di sisi lain mereka bisa kehilangan banyak karenanya. Valuta asing (forex) pasar telah menjadi salah satu instrumen investasi yang paling populer karena volatilitasnya. Pasar ini memiliki volatilitas tertinggi dibandingkan pasar lain. Dengan kondisi pasar seperti ini, para investor forex yang dituduh harus jeli dalam melihat peluang dengan memanfaatkan volatilitas pasar. Mereka harus mampu mengelola risiko secara efektif tanpa kehilangan keuntungan. Makalah ini akan mencoba untuk menemukan jalan untuk mengelola risiko dan keuntungan dalam trading forex harian per jam dengan menggunakan metode portofolio Markowitz modern dan Value at Risk (VaR) sebagai pertimbangan keterbatasan portofolio risiko dan mengevaluasi apakah portofolio tersebut cukup efisien menurut perbandingan antara risiko terburuk dari investasi tersebut terhadap tingkat pengembalian. Objek penelitian ini adalah lima pasangan mata uang yang paling diperdagangkan tukar, yang Dolar Australia / US Dollar (AUD / USD), Euro / US Dollar (EUR / USD), Great Britain Pound Sterling / US Dollar (GBP), Swiss Franc / US Dollar (USD / CHF), dan Yen Jepang / US Dollar (JPY / USD). Data harga per jam dari pasangan mata uang diperoleh selama periode tiga bulan magang (Februari April 2010) di Valbury Asia Futures. Kata kunci: pasar uang, pertukaran mata uang asing, risiko iii

5 FOREWORD The significant problems we face in life cannot be solved at the same level of thinking we were at when we created them - Albert Einstein. The quote above could be a reason why we have to learn every day. Every single day is about how to learn from the problem we face. Every lesson we have learned should bring us to a better way of thinking and behaving. With the better way of thinking and behaving we will be known how to live our life better. Study in SBM-ITB is one of the important learning stages in my life. SBM-ITB is the place where we learn about the meaning of teamwork, perseverance, happiness, disappointment, and so many things that has brought the colors in my journey to be a better person. Finally, after precious three years, I have arrived to the end of this one important learning stage. This final project is one of the requirements to be fulfilled to finish my S1 study in SBM-ITB. Alhamdulillah, it has been finished well. For that, I would like to say thank you to some parties that have been contributed to this final project completion: 1. The most merciful and the most graceful, ALLAH SWT. Praise the lord for all of the blessings and mercies, 2. Mr. Ir. Achmad Herlanto Anggono, MBA for all of the guidance during the completion of this final project. 3. My parents who always give our prayers, love, advices, affection, and enthusiasm every time. 4. Mr. Achmad Danu Prasetyo, S.T., MSM for the precious advices and guidance. 5. All of the SBM-ITB staffs, Mrs. Ikum, Mrs. Wiwid, Mr. Muji, and others that I could not tell one by one. Thank you for all of the meaningful helps and services. May the blessings of Allah will always be with you all. Finally, I hope this project can be useful for the reader, especially for my junior in SBM-ITB. iv

6 LIST OF CONTENTS ABSTRACT... ii ABSTRAK... iii FOREWORD... iv LIST OF CONTENTS... v LIST OF TABLES... vii LIST OF APPENDICES... viii CHAPTER I INTRODUCTION Background Problem Identification Objective Problem Limitation... 4 CHAPTER II LITERATURE REVIEW General Knowledge About Foreign Exchange Rate of Return Expected Return Variance & Volatility Portfolio Portfolio Expected Return Portfolio Risk Optimal Portfolio Using Efficient Frontier Value at Risk CHAPTER III METHODOLOGY Problem Identification Research Objective Literature Study and Data Collection Data Analysis Conclusion & Recommendation CHAPTER IV DATA ANALYSIS Expected Return Volatility v

7 4.3 Variance Covariance Table Correlation Table Efficient Frontier Portfolio Value at Risk CHAPTER V CONCLUSION AND RECOMMENDATION Conclusion Recommendation REFERENCES ATTACHMENTS vi

8 LIST OF TABLES Table 1-1 Geographical Distribution of Daily Average Foreign Exchange Turnover...3 Table 4-1 Expected Return of Each Currency 15 Table 4-2 Volatility of Each Currency Table 4-3 Variance Covariance Table Table 4-4 Correlation Table of Each Currency Table 4-5 Optimal Weighting of Each Currency Table 4-6 Optimal Portfolios on Five Major Currencies Table 4-7 Value at Risk for Each Confidence Level vii

9 LIST OF APPENDICES APPENDIX A HISTORICAL PRICE PER US DOLLAR FROM FEBRUARY 2010 TO APRIL 2010 (HOURLY) APPENDIX B RETURN PER US DOLLAR OF EACH CURRENCY FROM FEBRUARY 2010 TO APRIL 2010 (HOURLY) viii