As investors and market practitioners evaluate various investments, assessing the value of global currencies is a critical step. Global investors typically rely on such relative measures as purchasing power parity and the underlying real exchange rate, because these rates implicitly suggest expectations about future economic fundamentals. Real exchange rates are assumed to be driven by expected excess returns, expected real interest rate differentials, and long-run expected real exchange rates. Thus, having a superior understanding of this implicit currency value, both current and forecasted, should enable an investor to achieve superior investment returns.

The authors attempt to provide a more accurate currency valuation framework that affords a better understanding of a currency’s true value. After being adjusted for macro fundamentals, this framework can produce superior Sharpe ratios that are largely attributable to lower return volatility. These higher Sharpe ratios should help investment professionals achieve a superior risk–reward profile for their various portfolios.

Four factors are chosen to more accurately determine the value of a currency: productivity, export quality, net foreign assets, and output gaps. The authors use productivity as a variable because highly productive economies tend to persistently exhibit stronger exchange rates. Export quality is used because quality variations can lead to prolonged differences in price levels. Net foreign assets are included because these resources capture global imbalances that require exchange rate adjustments. Output gaps, the final variable, are used because they are an indicator of future expected interest rate differentials. The authors use a panel of exchange rates and macro fundamentals covering 23 advanced and emerging economies over 1970–2014 at a quarterly frequency. These data come mostly from the Global Financial Database; the export quality data come from the International Monetary Fund. These two sources also provide home-bias data. The authors then use Granger causality–type tests to determine whether the macro variables relate to exchange rate differentials by regressing these numbers on lagged fundamentals. Using regression analysis, they determine whether home bias influences exchange rate differentials, finding that those results are not statistically significant.

The results of this research suggest that investment professionals would benefit from diversifying away from such conventional strategies as carry and momentum. Investment professionals seeking to maximize returns for a given level of risk should consider this research and its findings when constructing portfolios and evaluating strategies.

The authors provide critical insight regarding the valuation of currencies from an asset-pricing standpoint. Market practitioners and research professionals should use these findings to better evaluate multicurrency investments and strategies. Further research that not only isolates instances in which a currency persistently deviates from its suggested value but also determines the economic causes and effects of that environment is needed.