Optimal and Naive Diversification in Currency Markets

36 Pages Posted: 11 Dec 2012 Last revised: 4 Feb 2016

See all articles by Fabian Ackermann

Fabian Ackermann

Zurcher Kantonalbank

Walt Pohl

NHH Norwegian School of Economics; University of Zurich

Karl Schmedders


Date Written: January 27, 2016


DeMiguel, Garlappi, and Uppal (Review of Financial Studies, 22 (2009), 1915-1953) showed that in the stock market, it is difficult for an optimized portfolio constructed using mean-variance analysis to outperform a simple equally-weighted portfolio because of estimation error. In this paper, we demonstrate that portfolio optimization can be made to work in currency markets. The key difference between the two settings is that in currency markets interest rates provide a predictor of future returns that is free of estimation error, which permits the application of mean-variance analysis. We show that over the last 26 years, a mean-variance efficient portfolio constructed in this fashion has a Sharpe ratio of 0.91, versus only 0.15 for the equally-weighted portfolio. We also consider the practical implementation of this strategy.

Keywords: Carry trade, currency, mean-variance analysis, portfolio optimization.

JEL Classification: F31, F37, G11, G12.

Suggested Citation

Ackermann, Fabian and Pohl, Walt and Pohl, Walt and Schmedders, Karl, Optimal and Naive Diversification in Currency Markets (January 27, 2016). Swiss Finance Institute Research Paper No. 12-36, Available at SSRN: https://ssrn.com/abstract=2184336 or http://dx.doi.org/10.2139/ssrn.2184336

Fabian Ackermann

Zurcher Kantonalbank ( email )

8010 Zurich, 8010

Walt Pohl

NHH Norwegian School of Economics ( email )

Helleveien 30
N-5045 Bergen

University of Zurich ( email )

Moussonstrasse 15
Zürich, 8044

Karl Schmedders (Contact Author)

IMD ( email )

Ch. de Bellerive 23
P.O. Box 915
CH-1001 Lausanne

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