Beyond the carry trade: optimal currency portfolios
Journal of Financial and Quantitative Analysis
Cambridge University Press
We test the relevance of technical and fundamental variables in forming currency portfolios. Carry, momentum and reversal all contribute to portfolio performance, whereas the real exchange rate and the current account do not. The resulting optimal portfolio outperforms the carry trade and other naive benchmarks in an extensive 16 year out-of-sample test. Its returns are not explained by risk and are valuable to diversified investors holding stocks and bonds. Exposure to currencies increases the Sharpe ratio of diversified portfolios by 0.5 on average, while reducing crash risk. We argue that currency returns are an anomaly which is gradually being corrected as hedge fund capital increases.
This article has been accepted for publication in the Journal of Financial and Quantitative Analysis and will appear in a revised form, subsequent to peer review and/or editorial input by Cambridge University Press. Copyright (c) 2013 Cambridge University Press