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Beyond the Carry Trade: Optimal Currency Portfolios

Published online by Cambridge University Press:  23 December 2015

Pedro Barroso  and
Pedro Santa-Clara
Pedro Barroso*
Affiliation:
[email protected], School of Banking and Finance, University of New South Wales, Sydney NSW 2052, Australia
Pedro Santa-Clara
Affiliation:
[email protected], Millennium Chair in Finance, Nova School of Business and Economics, 1099-032 Lisboa, Portugal, Center for Economic and Policy Research (CEPR), and National Bureau of Economic Research (NBER).
*
*Corresponding author: [email protected]
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Abstract

We test the relevance of technical and fundamental variables in forming currency portfolios. Carry, momentum, and value reversal all contribute to portfolio performance, whereas the real exchange rate and the current account do not. The resulting optimal portfolio produces out-of-sample returns that are not explained by risk and are valuable to diversified investors holding stocks and bonds. Exposure to currencies increases the Sharpe ratio of diversified portfolios by 0.5 on average, while reducing crash risk. We argue that besides risk, currency returns reflect the scarcity of speculative capital.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 50 , Issue 5 , October 2015 , pp. 1037 - 1056
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2015 

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