Cointegration and Asset Allocation: A New Fund Strategy

Many recent papers have documented the existence of periodicities in returns, return volatility, bid-ask spreads and trading volume, in both equity and foreign exchange markets. In this paper, we propose and employ a new test for detecting subtle periodicities in financial markets based on a signal coherence function. The technique is applied to a set of seven half-hourly exchange rate series. Overall, we find the signal coherence to be maximal at the 8 hour and 12 hour frequencies. Retaining only the most coherent frequencies for each series, we implement a trading rule based on these observed periodicities. Our results demonstrate in all cases except one that, in gross terms, the rules are able to generate returns considerably greater than those of a buy-and-hold strategy. We conjecture that this methodology could constitute an important tool for market microstructure researchers, which will enable them to better detect, quantify and rank the various periodic components in financial data.