Abstract
AbstractWe examine the potential gains of using exchange rate forecast models and forecast combination methods in the management of currency portfolios for three exchange rates: the euro versus the US dollar, the British pound, and the Japanese yen. We use a battery of econometric specifications to evaluate whether optimal currency portfolios implied by trading strategies based on exchange rate forecasts outperform single currencies and the equally weighted portfolio. We assess the differences in profitability of optimal currency portfolios for different types of investor preferences, two trading strategies, mean squared error‐based composite forecasts, and different forecast horizons. Our results indicate that there are clear benefits of integrating exchange rate forecasts from state‐of‐the‐art econometric models in currency portfolios. These benefits vary across investor preferences and prediction horizons but are rather similar across trading strategies.
Highlights
Foreign exchange risk is omnipresent in international portfolio diversification, but forecasting exchange rates is well known to be a difficult task
We provide an evaluation framework where we take the perspective of a currency portfolio manager who follows trading strategies based on exchange rate forecasts and whose main goal is to maximize profits, under certain types of preferences
In order to assess whether exchange rate forecasts based on macroeconomic fundamentals improve the profitability of currency portfolios, we investigate the performance of currency portfolios of returns implied by two strategies described above, which exploit the potential predictability of exchange rate changes
Summary
Foreign exchange risk is omnipresent in international portfolio diversification, but forecasting exchange rates is well known to be a difficult task. We provide an evaluation framework where we take the perspective of a currency portfolio manager (investor) who follows trading strategies based on exchange rate forecasts and whose main goal is to maximize (risk-adjusted) profits, under certain types of preferences. Unlike our study, Burnside et al (2008) do not test the statistical significance of the portfolio outperformance with respect to the single-currency-based asset While they use a simple, weighted portfolio, we take the investor's preferences into account explicitly and optimize the portfolio according to these preferences. Another fundamental difference with respect to their work is that we include exchange rate forecasts in the definition of our trading strategies with the aim of improving their performance.
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
