Optimal and Naive Diversification in Currency Markets

What is it about?

In the stock market, it is difficult for an optimized portfolio constructed using mean-variance analysis to outperform a simple, equally weighted portfolio because of estimation error. In this paper, we demonstrate that portfolio optimization can be made to work in currency markets. The key difference between the two settings is that in currency markets interest rates provide a predictor of future returns that is free of estimation error, which permits the application of mean-variance analysis. We show that over the last 26 years, a mean-variance efficient portfolio constructed in this fashion has a Sharpe ratio of 0.91, versus only 0.15 for the equally weighted portfolio. We also consider the practical implementation of this strategy.

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Why is it important?

Mean-variance analysis is better than its reputation.