Let the Parametric Phoenix Fly

Abstract

In international portfolios investors move away from domestic-only investing and diversify their allocation of assets by foreign equities. The exposure to foreign currencies adds an additional risk component which is managed in the currency overlay. To achieve an ideal weighting of the allocation of assets and the exposure to currencies, this study proposes a novel approach for a joint optimization. For the optimal weighting of equities we suggest to employ characteristics of momentum, value, and size strategies while currencies are allocated according to characteristics of carry trade, currency momentum, and currency value strategies. Relative to a benchmark and in an out-of-sample setting, we document an increase in the portfolios’ Sharpe ratio by 30% after transaction and rebalancing costs. This relative improvement is primarily driven by the increase in portfolios’ returns, while the portfolios’ overall volatility remains unaffected.

Keywords: asset allocation, currency overlay, portfolio choice, portfolio optimization

JEL Classification: F31, G11, G15