International Asset Allocation: A New Perspective

Abstract

A systematic empirical finding is that foreign exchange risk is priced in international markets. The theoretical foundation for virtually all empirical models is the seminal contribution by Adler and Dumas [1983]. In that paper, the authors show that, in an international economy in which the purchasing power parity (PPP) does not hold, the intertemporal market equilibrium will lead to a risk premium associated with currency risk. They obtain this result by using Merton's well-known result in intertemporal portfolio choice that at the optimum economic agents hedge against the fluctuations of each and every state variable driving the economy. Consequently, these hedging components lead to asset prices that in equilibrium include a risk premium for each and every state variable. Assuming a priori that one state variable is (related to) currency risk then leads to a currency risk premium. In contrast to this approach, we propose a new analysis of a representative investor's optimal strategy that leads to optimal currency risk hedging in a natural and general way without ad hoc assumptions. In our international economy, PPP is violated and financial asset real returns and real exchange rates follow general diffusion processes driven by K state variables. The optimal portfolio of an expected utility maximizer is shown to contain, in addition to the usual speculative component, only two hedging components, irrespective of the magnitude of K. The first one hedges domestic interest rate risk. The second one hedges the risk associated with the co-variation of the interest rates and the international market prices of risk, depends on interest rate differentials across countries and/or real exchange rates variability, and therefore encompasses hedging against PPP deviations. Thus our decomposition gives sound foundations as to why currency risk is hedged at the optimum and priced in market equilibrium.