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Optimal and Naive Diversification in Currency Markets

Author

Listed:
  • Fabian Ackermann

    (Zurcher Kantonalbank)

  • Walt Pohl

    (University of Zurich)

  • Karl Schmedders

    (University of Zurich)

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.

Suggested Citation

  • Fabian Ackermann & Walt Pohl & Karl Schmedders, 2012. "Optimal and Naive Diversification in Currency Markets," Swiss Finance Institute Research Paper Series 12-36, Swiss Finance Institute.
  • Handle: RePEc:chf:rpseri:rp1236
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    File URL: http://ssrn.com/abstract=2184336
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    1. repec:eee:ecolet:v:171:y:2018:i:c:p:93-96 is not listed on IDEAS

    More about this item

    Keywords

    Carry trade; currency; mean-variance analysis; portfolio optimization.;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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