What is it about?
We test the usefulness of currency characteristics to form currency portfolios and combine these with diversified investments in equities and bonds. We find that currency interest rates (carry), momentum, and value reversal all contribute to portfolio performance, whereas the real exchange rate and the current account do not. The resulting optimal portfolio produces performance out-of-sample returns that are not explained by risk and are valuable to diversified investors holding stocks and bonds. Exposure to currencies increases the Sharpe ratio of diversified portfolios by 0.5 on average, while reducing crash risk. We argue that besides risk, currency returns reflect the scarcity of speculative capital.
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Why is it important?
The paper brings a portfolio optimization approach to currency markets and shows that some stylized facts of these markets (as the crash risk of carry trade strategies) lose some importance in diversified portfolios. It examines several explanations for the intriguing performance of diversified portfolios including investments in currencies and concludes that the most likely explanation is that, over the sample period studied, speculative capital exploiting these investment opportunities was relatively modest. This represents a contribution to the understanding of currency markets and international economics in general.
Perspectives
The optimization approach in the paper does not exhaust the topic of combining equity with FX investments and the potential signals that can be used / tested. It opens the perspective of other equally pertinent joint optimizations across asset classes. On a more general note, its evidence points to a very gradual elimination of a sizable anomaly in the world's largest financial market. An alternative interpretation, is that it points to the need of better risk-based explanations compatible with very high (but declining) economic performance of investments in currency markets. Explaining both the impressive past performance and its gradual decline could prove to be challenging.
Dr Pedro Barroso
University of New South Wales
Read the Original
This page is a summary of: Beyond the Carry Trade: Optimal Currency Portfolios, Journal of Financial and Quantitative Analysis, October 2015, Cambridge University Press,
DOI: 10.1017/s0022109015000460.
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