Clearing up common misconceptions of currency portfolios

Abstract

Recent interest has centered on the use of an asset dominated in a basket of currencies instead of a single currency. The reason for this is derived from the reduction in the variance by diversifying assets into more than one currency. As tong as the currencies included in the basket are not perfectly correlated, the risk of holding that basket (as measured by variance) is reduced. The risk can be lessened to a larger extent if the correlation coefficients between the currencies included in the portfolio are small or negative. This diversification concept was applied when the Standard Drawing Rights (SDR's) were developed to be a substitute for the dollar as the reserve asset of central banks. In effect, the SDR's allow foreign countries to hold a reserve asset which has less volatility than the dollar as a medium for managed floating. This concept has also been examined for use in the international capital markets to reduce exchange rate risk. For the same reason, OPEC leaders have studied the possibility of substituting a basket of currencies for the dollar as apricing mechanism for oil.They have planned to implement this idea by the end of 1980. With the development of international finance, the forward market has been a means to hedge against exchange rate risk. Critics of currency-portfollo theory may suggest that the forward market will allow international money managers to cover themselves at no additional cost when holding an asset representing a single currency. However, there are extra costs to hedging. First, a transaction fee is associated with forward purchases of currency. Also, the act of hedging against long term exchange rate risk requires a long term forward market which is not available. There is some question as to how effective the forward market would be in reducing risk when holding ten or 20 year bonds denominated in one currency. With regard to OPEC's pricing of oil the same argument follows. Critics suggest that those OPEC countries accepting dollars for oil could stabilize their import purchasing power through buying other currencies forward with dollars. As the dollars are received, they would be delivered in return for other currencies at a given exchange rate agreed upon in the past. Although this insulates OPEC countries for short term periods from dollar depreciation against foreign currencies, it provides no long term security. Second, OPEC desires to avoid variable transaction fees associated with the persistent forward trading of dollars for other currencies. To summarize, some uses of currency portfolios have been mentioned. Certain misconceptions have developed resulting in the misunderstanding that hedging can be substituted instead of a basket of currencies for the given situations. Hedging techniques, though valuable, require transaction costs and maturity constraints and are therefore not perfect substitutes for currency portfolio implementation.