Professor of Finance
Forward exchange rates are not unbiased predictors of future spot rates: currencies with lower nominal interest rates on average depreciate against currencies with higher nominal interest rates.The authors show how an investor can form portfolios of currencies that benefit from the forward bias and that trade off risk and return optimally. They find that applying a mean-variance analysis under the assumption that exchange rates behave as random walks (an assumption motivated by the fact that exchange rate changes do not seem to be predictable using any plausible set of macroeconomic variables) leads to portfolio weights that are stable over time without resorting to exogenous constraints on weights.Optimal currency portfolios invested in the German deutschemark, the Japanese yen, the British pound, and the Swiss franc with the U.S. dollar as the risk-free asset generate an average excess return of 2.79% per year over the period 1989 through 1999. The Sharpe ratio on these returns is better than that on a U.S. Treasury index and that on a global Treasury index (unhedged for currency risk). Moreover, the returns are uncorrelated with major fixed-income and equity indexes.These findings suggest that the methodology can provide a useful benchmark for fund managers interested in optimal currency overlays.