Sparse and stable international portfolio optimization and currency risk management

Raphael Burkhardt and Urban Ulrych

Journal of International Money and Finance, 2023, vol. 139, issue C

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.

Keywords: International asset allocation; Currency risk management; Currency overlay; Shrinkage; Sparsity; Stability; Regularization; Mean-variance optimization (search for similar items in EconPapers)
JEL-codes: C61 F31 G11 G15 (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:139:y:2023:i:c:s026156062300150x

DOI: 10.1016/j.jimonfin.2023.102949

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