Currency Investing in Global Portfolios: Hedging or Speculative Benefits?

Abstract

This paper investigates whether and how currency strategies can enhance the performance of international bond and equity portfolios. Currency positions may deliver hedging benefits, pure investment, i.e. speculative benefits, or both simultaneously. We develop a new test that decomposes the total change in Sharpe ratio resulting from adding currency positions to any risky portfolio, into the share due to hedging and the share due to speculative benefits of currencies. This allows us to identify, measure and compare economically and statistically these two sources of value added. Based on stock and bond returns from 12 developed countries between 1975 and 2007, we find that adding currency deposits to international equity or bond portfolios significantly enhances their performance, leading to a doubling of their Sharpe ratios. Our decomposition shows that, while economically non-negligible, the hedging benefits of currency positions are not statistically significant. Most of the performance enhancement delivered by currency positions can be attributed to their speculative benefits, which are both economically large and highly statistically significant. These results are robust for various static and dynamic investment strategies and for investors with different home currencies.