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

University of Zurich

Date Written: January 27, 2016

Abstract

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 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 )

Postfach
8010 Zurich, 8010
Switzerland

Walt Pohl

NHH Norwegian School of Economics ( email )

Helleveien 30
N-5045 Bergen
Norway

University of Zurich ( email )

Moussonstrasse 15
Zürich, 8044
Switzerland

Karl Schmedders (Contact Author)

University of Zurich ( email )

Moussonstrasse 15
Zürich, CH-8044
Switzerland
+41 (0)44 634 3770 (Phone)

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