Cointegration-based optimisation of currency portfolios

Abstract

Cointegration is a technique that has been used for some time to optimise equity portfolios, but there is limited evidence of its application in managing currency portfolios. This research examines whether there is any value to be gained by using cointegration-based strategies to optimise currency portfolios that are US dollar, euro and sterling based, respectively. We build ‘major currency pair tracking’ portfolios to replicate the classic index tracking strategy commonly applied to equity portfolios, overcoming the lack of an ‘index’ for currencies by using the most frequently traded currency pair for each portfolio, namely the EUR/USD for the US dollar and euro portfolios, whereas the GBP/USD is used for the sterling portfolios. We compare the out-of-sample performances of these portfolios to simple benchmark techniques of optimisation. The results are encouraging, with the detection of long-run relationships adding value, particularly for the sterling portfolios. Owing to the generally low volatile nature of the cointegration portfolios, they could be leveraged to match the returns being offered to investors by the benchmarks, as they generally offered better risk-adjusted returns. They also enhance portfolio stability. There are several side issues that are also discussed, such as whether profits can still be derived from applying simple trading rules to currency portfolios, and if so what are the best currencies to invest in and how far should an investor internationally diversify their portfolios. Some of the results found are encouraging, and point towards the added value given by ‘lesser’ currencies, particularly the Scandinavian currencies, with the Swedish Krona appearing to boost the risk-adjusted returns of portfolios. Technical analysis is shown to still have a role to play in currency trading.