Do exotic currencies improve the risk-adjusted performance of dynamic currency overlays?

Abstract

This paper investigates the benefits of additional international diversification into emerging stock markets, from the point of view of a US investor. The increase in risk-adjusted returns with exotic currencies (compared with a benchmark portfolio of only major currencies investments) is achieved through the use of a currency overlay programme. The impact of the exotic currency overlay programme is assessed, using daily closing prices for several international stock markets and currencies. Portfolio returns and volatility are analysed through the use of a dynamic hedge based on a simple technical trading rule strategy. The performance is compared with a static hedge and an unhedged position over the period January 1994 to June 2000. The results indicate that the use of an overlay to protect currency exposures adds to the risk-adjusted returns of the portfolio. In particular, the use of exotic currencies is proven to add superior risk-adjusted returns before and after the addition of transaction costs, compared with an overlay of only major currency pairs to the US dollar. The results suggest that a greater potential for gains is available from exotic currency hedging using trend-following techniques than is the case with major currency pairs to the US dollar. They therefore demonstrate a further benefit of international diversification to emerging markets.