Aurora Borealis
1 September 2016 CFA Institute Journal Review

Beyond the Carry Trade: Optimal Currency Portfolios (Digest Summary)

  1. Marvin Powell, CFA

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.

What’s Inside?

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 returns.

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.

Abstractor’s Viewpoint

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.

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