Abstract
Financial planning books and academic papers in the U.S. have since long analyzed the horizon effects that arise in domestic investments. In this paper we try to assess whether mean reversion in real exchange rates (RER) can induce horizon effects in international portfolio allocation. We estimate and introduce a long memory (ARFIMA) RER model into an optimal portfolio allocation framework where a representative investor can access domestic and international stocks. Our results show that there are significant horizon effects for the buy and hold investor, and that they depend upon the initial value of the RER compared to its long run value. Horizon effects disappear for the optimal rebalancing case. We argue that intertemporal hedging demands for foreign stocks are small given the low correlation between realized and expected returns.
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