Investing in currencies significantly improves the performance of a diversified
portfolio exposed to stocks and bonds. Prior studies examined currency
investment strategies, such as carry, value, and momentum, but the authors
attempt to study the optimal combination of these currency strategies in the
context of a portfolio including stocks and bonds.
Statistically significant abnormal returns should not exist in efficient
markets—or in markets permeated with speculative capital; currency markets,
however, have high levels of price-insensitive capital, which tends to give rise to
time-persistent market anomalies. These anomalies can be exploited by combining
various currency investment strategies. For example, during the recent financial
crisis, a carry exchange-traded fund (ETF) lost 32.6%, whereas a momentum ETF
returned 29.4% and a value ETF returned 17.8%. This research determines that
including these currency strategies in an optimized portfolio increases the Sharpe
ratio by 0.51 while reducing fat tails and left skewness.
How Is This Research Useful to Practitioners?
Market participants are tasked with continuously monitoring and analyzing financial
markets to identify superior investment opportunities. Portfolio managers and
investment professionals must therefore determine the proper amount of exposure to
these investments and attempt to construct an optimal portfolio that balances both
risk and reward. As such, investment opportunities need to be evaluated both in
isolation as well as in the context of the overall portfolio.
The authors conclude that including carry, value, and momentum currency investment
strategies in an optimized portfolio will significantly improve the risk and reward
relationship of the overall investment portfolio. Investment professionals should be
aware of this opportunity and determine if including this currency investment
strategy is suitable to achieve the goals of the overall portfolio. If employing
these currency strategies—or any strategy, for that matter—will improve
the risk and return profile of the investment portfolio, it would be prudent for the
market practitioner to evaluate the appropriateness of implementing such a strategy.
As central banks continue to intervene in currency markets and as corporations hedge
currency exposure, this research presents opportunities for profit-seeking
individuals to capitalize on these market inefficiencies to deliver superior
How Did the Authors Conduct This Research?
The authors use data on exchange rates, the forward premium, and the real exchange
rate for the eurozone and the 27 member counties of the OECD. The exchange rate data
are from DataStream, and the real exchange rates of each currency against the US
dollar are calculated using the spot exchange rates and the Consumer Price Index
from the OECD Main Economic Indicators database. To study the risk and return of
currency strategies, a parametric portfolio approach is used to test the relevance
of different variables when constructing currency portfolios. The authors use a
pre-sample test with 20 years of data up to 1996 to determine which characteristics
were significant. They test the relevance of the interest rate spread, momentum, and
three proxies for value: long-term value reversal, the real exchange rate, and the
current account. Then the authors conduct an out-of-sample exercise with 16 years of
monthly returns. They then regress the returns of the optimal strategy on the level
of speculative capital in the market to discover that the expected returns decline
as the amount of hedge fund capital increases.
The authors attempt to evaluate the impact of including various currency investment
strategies in the context of the overall investment portfolio. The findings support
the notion that a properly diversified portfolio is able to deliver superior
investment results. Ultimately, I would like to see further research expand on these
findings to determine the effectiveness of these investment strategies during other
time frames as well as to identify scenarios in which this investment strategy may
not be appropriate.