Optimal Currency Allocation to Add Alpha and Reduce Risk

Abstract

We propose a framework for optimal currency allocations taken relative to a strategic benchmark, which may build in existing hedging positions. We determine optimal currency positions to obtain higher expected returns than the benchmark holding the risk constant, or to reduce risk but hold the expected return of the benchmark constant, or both. The currency exposures relative to the strategic benchmark are considered jointly across all asset classes and currencies. We make the intuition explicit in a theoretical setting without constraints and empirically illustrate the framework with two portfolios: a representative portfolio for a Wealth manager denominated in Euros and a typical pension fund portfolio denominated in Pounds. Optimal currency allocations to reduce risk tend to hedge all or a significant fraction of currency exposures for both portfolios. We find certain hedges, like to Australian dollars for the Euro Wealth investor and Japanese Yen for the GBP pension portfolio, to be optimal to maximize returns with the same risk as the strategic benchmark.