Sparse and Stable International Portfolio Optimization and Currency Risk Management

Raphael Burkhardt and Urban Ulrych
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Raphael Burkhardt: University of Zurich - Department of Banking and Finance
Urban Ulrych: University of Zurich - Department of Banking and Finance; Swiss Finance Institute

No 22-07, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: This paper introduces a sparse and stable optimization approach for a multi-currency asset allocation problem. We study the benefits of joint optimization of assets and currencies as opposed to the standard industry practice of managing currency risk via so-called currency overlay strategies. In our setting, a classical mean-variance problem in an international framework is augmented by several extensions that aim at reducing parameter uncertainty related to the input parameters and induce sparsity and stability of the asset and currency weights. These extensions integrate maximal net exposure to foreign currencies, shrinkage of the input parameters, and constraints on the norms of the asset- and currency-weight vectors. The empirical performance of the portfolio optimization strategies based on the proposed regularization techniques and the joint (i.e., asset and currency) optimization is tested out of sample. We demonstrate that the sparse and stable joint optimization approach consistently outperforms the standard currency overlay as well as the equally-weighted and the non-regularized global portfolio benchmarks net of transaction costs. This result shows that the common industry practice of employing currency overlay strategies is suboptimal and can be improved by a joint optimization over assets and currencies.

Keywords: International Asset Allocation; Currency Risk Management; Currency Overlay; Shrinkage Estimation; Regularization; Mean-Variance Optimization (search for similar items in EconPapers)
JEL-codes: C61 F31 G11 G15 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2022-01
New Economics Papers: this item is included in nep-ifn, nep-opm and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2207

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