The Impact of Currency Exposure on Institutional Investment Performance: The Good, the Bad, and the Ugly

51 Pages Posted: 16 Jan 2014

See all articles by Momtchil Pojarliev

Momtchil Pojarliev

Fischer Francis Trees & Watts, Inc.

Richard M. Levich

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Ross M. Kasarda

Virginia Retirement System

Date Written: January 12, 2014

Abstract

Institutional investor portfolios typically hold a significant allocation of foreign currency denominated assets. Very often at least some of this currency exposure has been viewed as bad or unwanted. On the other hand, recent studies have concluded that currency is itself an asset class that offers investors favorable risk-adjusted returns that could benefit a typical portfolio of stocks and bonds.

There are two basic types of currency management mandates. In a currency hedging mandate (currency overlay), investors strive to manage (usually meaning reduce) the risk associated with the foreign currency exposure in their international assets. With an absolute return mandate (currency alpha), investors seek to earn a positive return subject to acceptable risk levels. The existing literature analyses these two basic types of currency management mandates separately. In this study, we investigate their impact on institutional investment performance simultaneously.

We find that both absolute return and currency hedging mandates can have a positive impact on the portfolio risk/return characteristics. Absolute return mandates have the potential to increase the portfolio return with little impact on volatility. Risk reduction mandates tend to reduce portfolio volatility with little impact on returns. Due to the safe haven status of the U.S. Dollar, higher hedge ratios provide diversification for US dollar based investors when needed most, namely in periods of negative equity returns. Combining both currency hedging and absolute return mandates improves overall investment performance while allowing managers to stay within their portfolio risk budget.

Keywords: Foreign Exchange, Portfolio Construction, Alpha Generation, Risk Budgeting

JEL Classification: F31, G15, G23

Suggested Citation

Pojarliev, Momtchil and Levich, Richard M. and Kasarda, Ross M., The Impact of Currency Exposure on Institutional Investment Performance: The Good, the Bad, and the Ugly (January 12, 2014). Available at SSRN: https://ssrn.com/abstract=2378987 or http://dx.doi.org/10.2139/ssrn.2378987

Momtchil Pojarliev

Fischer Francis Trees & Watts, Inc. ( email )

200 Park Avenue, 11th Floor
New York, NY 10166
United States

Richard M. Levich (Contact Author)

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0422 (Phone)
212-995-4256 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Ross M. Kasarda

Virginia Retirement System ( email )

VA
United States
804-344-3106 (Phone)

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