International Diversification Benefits with Foreign Exchange Investment Styles

Abstract

Die Dis cus si on Pape rs die nen einer mög lichst schnel len Ver brei tung von neue ren For schungs arbei ten des ZEW. Die Bei trä ge lie gen in allei ni ger Ver ant wor tung der Auto ren und stel len nicht not wen di ger wei se die Mei nung des ZEW dar.Dis cus si on Papers are inten ded to make results of ZEW research prompt ly avai la ble to other eco no mists in order to encou ra ge dis cus si on and sug gesti ons for revi si ons. The aut hors are sole ly respon si ble for the con tents which do not neces sa ri ly repre sent the opi ni on of the ZEW.Download this ZEW Discussion Paper from our ftp server:ftp://ftp.zew.de/pub/zew-docs/dp/dp11028.pdf Abstract This paper provides a comprehensive analysis of portfolio choice with popular foreign exchange (FX) investment styles such as carry trades and strategies commonly known as FX momentum, and FX value. We investigate if diversification benefits can be achieved by style investing in FX markets relative to a benchmark allocation consisting of U.S. bonds, U.S. stocks, and international stocks. Overall, our results suggest that there are significant improvements in international portfolio diversification due to style-based investing in FX markets (both in the statistical, and most importantly, in the economic sense). These results prevail for the most important investment styles after accounting for transaction costs due to re-balancing of currency positions, and also hold in out-of-sample tests. Moreover, these gains do not only apply to a mean-variance investor but we also show that international portfolios augmented by FX investment styles are superior in terms of second and third order stochastic dominance. Thus, even an investor who dislikes negatively skewed return distributions would prefer a portfolio augmented by FX investment styles compared to the benchmark. Non-technical SummaryJEL-Classification: G11, G12, G15

Dynamic Global Currency Hedging

“…For the CMV strategy, this corroborates the in-sample findings in Campbell et al (2010, Table VII), improves the statistically insignificant evidence in Kroencke et al (2014), and contrasts with the findings in Glen &Jorion (1993) andde Roon et al (2003). Furthermore, this constitutes the first statistical evidence in favor of the realized currency beta hedging approach, advanced in this paper.…”

“…Similarly to the design of the pseudo-dynamic hedging strategies in Glen & Jorion (1993) Even though the inclusion of traditional foreign exchange rate trading strategies in the present setting yields no further volatility reductions, this does not mean that their inclusion in speculative asset allocation problems will not impact portfolio performance, see, e.g., Kroencke et al (2014). Thus, although analysis of speculative asset allocation in a second step portfolio analysis is beyond the scope of the present paper, the performance of currency carry trade, momentum, and value strategies is used to provide further perspectives on the realized currency beta hedging strategies next.…”

“…Some studies have analyzed hedging strategies that go beyond simple rule-ofthumb guides. In particular, Glen & Jorion (1993), de Roon, Nijman & Werker (2003), Campbell, de Medeiros & Viceira (2010), Schmittmann (2010), Kroencke, Schindler & Schrimpf (2014), and Opie & Dark (2015) analyze diversification benefits from optimal hedging strategies based on the theory originally proposed by Anderson & Danthine (1981), albeit with mixed empirical results. 2 Whereas they all reject leaving international investments unhedged, the first two studies find no significant evidence that a static optimal hedging strategy provides diversification benefits beyond what can be achieved by fully hedging international equity investments.…”

On optimizing risk exposures with trend-following strategies in currency overlay portfolios

“…Different to Kroencke et al (2014) and Gyntelberg and Schrimpf (2012), this paper focuses on a single FX strategy style underlying a momentum-based trend following approach in the currency overlay portfolios as discussed in the literature. The momentumbased approach is similar to those in Kroencke, et al (2014), except that they use different variables.…”

“…The momentumbased approach is similar to those in Kroencke, et al (2014), except that they use different variables. Their momentum portfolio goes long in a portfolio of currencies with the highest past cumulative returns (so-called "winners") and short in a portfolio of currencies with the lowest past returns (so-called "losers").…”