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We study the economic value of market timing in foreign exchange (FX) markets, that is, using information about the conditional Sharpe ratio to adjust the notional value of a conditionally mean–variance efficient currency portfolio. Our strategy trades more (less) aggressively when the conditional risk-return trade-off is more (less) favorable. This leads to a significant improvement in the out-of-sample unconditional Sharpe ratio, skewness, and maximum drawdown per 1% expected excess return. The strategy’s market timing predicts returns, volatility, and skewness in FX markets. Popular currency pricing factors do not explain the strategy’s high average excess returns. Our findings suggest that it is costly to impose leverage or risk (i.e., conditional volatility) limits or other inferior market timing policies when constructing currency trading strategies.

We introduce the concept of risk entanglement in a preference-free setting to jointly explain the exchange rate volatility, cyclicality, and currency risk premia in the data. Risk entanglement specifies a subset of incomplete market models, in which nondiffusive or nonlog-normal shocks to exchange rates are not fully spanned by asset returns. When risks are entangled, there exist multiple pricing-consistent exchange rates, but none of them are equal to the ratio of the stochastic discount factors (SDFs) or their projections. Decoupling the exchange rate from the SDFs allows us to address key FX market patterns that are puzzling in international finance.

From a private banking practitioner to a scholar, Dr. Maurer is a romantic man driven by interests instead of gold. Keen on knowledge sharing, Dr. Maurer hopes that he could induce positive impacts on students.