Sparse and stable international portfolio optimization and currency risk management

Abstract

This paper introduces a sparse and stable optimization approach for multi-currency asset allocation, aiming to improve portfolio performance and currency risk management. We demonstrate that the widespread industry practice of employing currency overlay strategies is suboptimal. In contrast, our proposed regularized joint optimization approach, which integrates assets and currencies, consistently outperforms currency overlay strategies as well as equally-weighted and non-regularized global portfolio benchmarks net of transaction costs. On average, the joint optimization approaches achieve 23.3% higher out-of-sample Sharpe ratios compared to their currency overlay counterparts. By addressing parameter uncertainty and inducing sparsity and stability, our method enhances the mean-variance framework, resulting in improved out-of-sample portfolio performance. These findings challenge the prevailing practice of employing currency overlay strategies and highlight the potential for additional gains in risk-adjusted returns through the joint optimization of assets and currencies.