Optimal Currency Strategies Under Deviations From Interest Parity

This paper examines optimal currency demands for global equity and bond investors in a large cross-section of developed and emerging markets over the 1975-2023 period. It extends the framework of Campbell et al. (2010) by incorporating both optimal portfolio-risk minimizing currency exposures, accounting for empirically measured hedging costs arising from deviations of Covered Interest Parity (CIP), and optimal expected-return-driven currency demands based on non-zero expected excess currency returns arising from empirically measured deviations of Uncovered Interest Parity (UIP). The analysis shows that the main conclusions of their portfolio risk-minimizing framework hold for this larger and longer panel of countries and that they are robust to deviations from CIP. Specifically, it is optimal for portfolio risk-minimizing equity investors to hold exposures to the U.S. dollar and the euro while avoiding exposure to all other currencies, whereas bond investors should hedge all currency exposures. In contrast, observed deviations from UIP are sufficiently large and persistent among currencies with high average relative interest currencies, especially Emerging Markets currencies, to generate expected return-driven currency demands that offset, and in some cases reverse, portfolio-risk minimizing demands, even for investors with low risk tolerance. The average excess returns on those currencies are large enough to compensate investors for their substantial return volatility and strong positive covariance with equity returns.