Weak Interest Rate Parity and Currency Portfolio Diversification

Abstract

This paper presents a dynamic model of optimal currency returns with a hidden Markov regime switching process. We postulate a weak form of interest rate parity that the hedged risk premiums on currency investments are identical within each regime across all currencies. Both the in-sample and the out-of-sample data during January 2002 - March 2005 strongly support this hypothesis. Observing past asset returns, investors infer the prevailing regime of the economy and determine the most likely future direction to facilitate portfolio decisions. Using standard mean variance analysis, we find that an optimal portfolio resembles the Federal Exchange Rate Index which characterizes the strength of the U.S. dollar against world major currencies. The similarity provides a strong implication that our three-regime switching modelis appropriate for modeling the hedged returns in excess of the U.S. risk free interest rate. To investigate the impact of the equity market performance on changes of exchange rates, we include the S&P500 index return as an exogenous factor for parameter estimation.