Publications

Journal Article

The contributions of the authors' analysis are twofold. First, they show how to apply mean-variance analysis to construct an optimal portfolio of currencies. The key assumption is that exchange rates behave as random walks. This assumption is motivated by the fact that exchange rate changes do not seem to be predictable using any plausible set of macroeconomic variables. This methodology results in stable portfolio weights over time and does not require exogenous constraints on weights.

Second, they find that 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 November 1989 through June 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.