Are currencies an attractive asset class?

Rajeev Seth†
October 10, 2004

(unpublished)

Abstract

This paper discusses whether currencies may be considered to be an attractive asset class in their
own right. Or should one just hedge currency risk in portfolios? The risk-return tradeoffs of
currencies are explored, advocating the thesis that currencies should be considered as a separate
asset class.

†
Rajeev Seth is graduate of the Master’s in Financial Engineering program at the University of California at Berkeley
Are currencies an attractive an asset class? Rajeev Seth

Portfolio Management and Asset Classes

Asset allocation in portfolio management, or choosing the right mix for investments, has been shown by empirical
evidence to be the single most important determinant of portfolio performance. In well-diversified portfolios, studies
have shown that asset allocation decisions explain over 90% of the difference in plan returns [4]. The reason asset
allocation is so important to an investment strategy is because it helps determine how much risk one can take with an
investment and balance it with its potential return. By diversifying across asset classes one can hedge one’s bets, taking
advantage of an asset class that is currently in favor and, while the same time, guarding against losses when that same
asset class goes out of favor.

It is important to invest across the spectrum of asset classes to adhere to the time-honored principle of not putting all
your eggs in one basket. Wise investing involves diversifying your asset categories. To put it very generally, different
asset classes behave differently at different times. If one of your investments in a certain asset class takes a turn for the
worse, the possibility exists that another investment in another asset class may be moving up. Diversifying sufficiently
lets the overall return on your combined portfolio remain positive even if one asset class under-performs.
Most people are familiar with taking decisions to invest in a limited, traditional universe of one or more of the
following asset classes:

• Cash
• Stocks
• Bonds
• Real-estate and REITs, etc.

However, they may not have considered other, less traditional asset classes such as foreign currencies. In the process,
they probably overlooked a financially very attractive asset class for the informed investor. Bear markets can force
money managers to think creatively and extend their investment universe to include non-traditional asset classes. The
market environment of the last several years with its steep equities market decline has led many financial professionals
to use foreign currency as an asset class to counter the meager returns of equities and bonds. Even renowned investor
Warren Buffet has been reported to have made record profit in 2003 using currency as a strategic asset class, while
eschewing new stock investments. The world's second wealthiest person, in his annual letter to shareholders in May
2004, said by the end of 2003, Berkshire held positions in five foreign currencies totaling $12 billion. He said he began
investing in foreign currency for the first time in 2002 as a result of the widening U.S. trade deficit.

Attributes of an asset class

An asset class is a set of “homogenous“ securities, whose prices are affected by a common factor. The segmentation of
asset classes is usually based on various criteria, e.g.,

• Asset type (equity, debt, real estate)

• Geography (international versus domestic or regional investments)
• Sector (tech stocks, energy stocks, high yield bonds, etc.)
• Style (growth versus value stocks)
For tactical asset allocation, investors may periodically decide which asset classes are attractively priced, making short
term departures from their long-term policy by buying more of the attractive markets. Through this process, they would
be aiming to add value by achieving a higher return than the return that would be achieved by simply holding the
portfolio defined by the long-term policy. Deviations from the long-term policy are based on short term developments
and reflect forecasts on market trends in the next few months.
Currencies as an asset class

Intuitively, one would think that currencies could not be a distinct asset class as their expected return would be zero,
unlike stocks which have a positive expected return due to the fundamental premise of growing corporate profits being
reflected in stock prices. But, anyone who held US dollars as cash and observed the worsening US current account
deficit (which is now about 5% of the US GDP) over the 2001-2003 timeframe could have guessed on the forthcoming
dollar depreciation, moving some of his savings from US dollars to the Euro and be sitting on a tidy profit. US savers
can lose money even if they are just holding cash in a currency that devalues, and in that sense at least, currency is just
another asset class like shares, bonds and real estate.

In fact, it may be shown that the expected return of this currency asset class is not zero. Uncovered interest rate parity
is not a good description of the empirical world. Forward rates in currencies are not unbiased. One can forecast how

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forward currency rates are going to miss the realized spot rates. This means profits can be made by observing how
forward rates predict the movement of the future spot currency rate. These profit opportunities are not riskless, but they
are certainly present and may be exploited with some expected volatility.

Even with the inherent risks of currency trading, skilled forex traders can generate profits by capitalizing on currency
fluctuations. So, while international political uncertainty in recent years has hurt stock markets around the globe,
currency specialists have posted returns by betting correctly--even when faced with wars, disruptions in oil supplies and
financial instability in emerging markets.

Currencies should be treated as a separate asset class also because they represent a direct participation in the real
economy of the world. The motivation for investing in currencies may range from the diversification benefits
achievable by a passive investor to the speculative profits sought by an active investor. The design of the investment
vehicle that would be used by the prospective investor would reflect these different motivations.

Findings of other studies

Perold and Schulman [2] suggest that it is better to formulate long-run investment policy in terms of hedged portfolios
than unhedged portfolios, since they view currency hedging as having zero expected return. “Therein lies the free
lunch: On average, currency hedging gives you substantial risk reduction at no loss of expected return” [Table 1 in
Appendix] Most of the time this may be true, but I did not find it to be true in an empirical test of a 10 year sample
period of FTSE-100 returns, where the expected return of the hedged portfolio reduced while lowering its risk. Since I
do not find their thesis to be true, I suggest that one make active investment decisions using unhedged portfolios chosen
for expected currency movements. For example, in the last two years, one might have invested in unhedged
international stock or bond funds to gain from an expected dollar depreciation.

Jorion’s findings [1] support my claim that currency is a valid, distinct asset class. Jorion studied the risk and return
characteristics of foreign stocks and bonds when those assets are stripped of their currency risk, finding that hedged
foreign stocks and bonds are worthy of being regarded as two new asset classes. He recommends gaining diversification
in interest rates across the world by investing in foreign bond markets and not subjecting oneself to the ups and downs
of US monetary policy alone. He found that the total volatility of foreign stocks, viewed as an asset class, was hardly
greater than that of the US stock markets, demonstrating that there are strong diversification effects across foreign
markets and currencies. In a strong dollar period, hedged foreign assets had both higher return and lower risk than US
assets. For long periods of time, foreign stocks also had a higher excess return as well, such as from 1970–1980 [Solnik
and Noetzlin], and by 7.1% in Jorion’s 1978-1988 study. On top of this, hedging currency risk using rolling forward
contracts was estimated to cost only about 2% per year affirming that currency hedging could indeed be a ‘free lunch’
by being a modest cost for the amount of risk reduction provided.

Jorion’s table 1 (see Appendix) across various sub-periods reports very low pairwise correlation coefficients (0.2 to
0.43) suggesting that there are diversification benefits to be gained by investing in foreign stocks and bonds. The low
values can be explained by the different cycles in income and monetary policies across national borders. That translates
into non-synchronous movements in US market risk and exchange rate and foreign market risk.

“With the increased openness of the US economy, cost of living is likely to be increasingly affected by currency
movements. Foreign investments should be viewed as a hedge against imported inflation, which means measuring
foreign asset returns in nominal terms overstates their risk.” This provides further support to my assertion that an
investor making active currency decisions can expect higher returns on his overall worldwide portfolio.

Odier and Solnik [5] find that global asset allocation can provide better risk-adjusted profit opportunities because a
diversified world stock index constructed by combining various national stock markets is quite inefficient on the mean-
variance efficient frontier when the universe of all national stock markets is included. [See figure G in Appendix] The
astute investor may exploit this inefficiency by using currency as an asset class.
International Capital Asset Pricing Model (ICAPM)

ICAPM proposes a passive investment strategy, or a benchmark for simplified global asset management. Domestic
CAPM tells us that the equilibrium expected return of an asset should be equal to the risk-free rate plus a risk premium
proportional to the covariance of the asset return with the return on the market portfolio. If we expand our investment
universe to include international assets, this domestic CAPM may be extended in an international context, and investors
in different countries use different currencies and have different consumption preferences. Such an ICAPM would
involve the domestic rate for the risk free rate and the market cap weighted portfolio of all the risky assets in the world
for the market portfolio. This ICAPM rests on these assumptions:

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• Investors throughout the world have identical consumption functions

• Real prices of consumption goods are identical in all countries, so PPP holds exactly all the time.

If this perfectness existed, exchange rates would simply be the inflation differential between two countries. However,
since these two assumptions do not hold, real prices of consumption goods are not identical and hence a real exchange
rate/foreign currency risk exists.

All international investors should want to hedge against this real foreign currency risk. They would be operating in the
context of ICAPM, which is developed under the assumption of investors wanting to evaluate investment risks and
returns in their domestic currency. Hence foreign currency risk premium is relevant. So, the expected domestic
currency return on a foreign currency investment is equal to the foreign risk-free rate plus the expected percentage
movement in the exchange rate.

Is this currency risk priced?

Studies have found that expected returns and risk in the currency markets are not constant over time. Dumas and Solnik
(1995) modeled the time variation in expected return and risk (conditional tests). They found that significant currency
risk premiums exist, and they rejected a model that would exclude currency risk factors. De Santis and Gerard (1998)
found strong support for a specification of the ICAPM that includes both market risk and currency risk. They stress the
importance of a conditional approach allowing variation in market and currency risk premiums. The lesson for asset
managers is to do periodic tactical revisions in their global asset allocation.
There are good grounds for believing that, over relatively short periods, the expected return from currency hedging
(equivalently, currency exposure) will be non-zero. Therefore, my opinion is that an active investor can exploit this
belief and tilt his portfolio towards an added currency exposure by being in close touch with the changing dynamics of
currency markets.

Implementing active currency decisions

Therefore, each investor should establish a base currency such as the US dollar for US residents, target excess return, and
risk profile. Institutional investors, with their relatively easy access to currency markets, may consider adding currencies
to their arsenal as another strategic asset class in the category of international investments. Individual investors may
consider investing in a managed currency fund, or a currency-based index fund (or currency ETF, if one is available). It
is quite likely that it is hard for the ordinary investor to gain access to such investment vehicles due to the current state
of legal and regulatory requirements which have prevented currency ETF like funds from being offered to the masses.
This is probably not due to insufficient demand, or lack of awareness of the investment public, but rather just a
tardiness on the part of regulators in catching up with globalized investing times.

If unable to invest in currency funds, investors may acquire a proxy effect of currency movements by investing through
a international stock or bond fund that is not currency-hedged. Odier and Solnik [5] find that the returns on a bond
investment in a foreign country are strongly influenced by the performance of that country’s currency (more so than
stock investments). They observe that national monetary/budget policies are not fully synchronized across countries,
and this relative independence of national monetary/budget policies influences both currency and interest rate
movements in a way that leads to a very low correlation between the US-dollar returns of the US and foreign bond
markets. Hence, the prospective currency investor is best off using the target country’s (e.g. Japanese) or region’s (e.g.
European) unhedged bond fund. Figure O from [5] in the Appendix shows the ultra-low correlations with Japanese
bonds (of the order of 0.2) Figure N shows that US stocks and EAFE stocks have a higher correlation of the order of
0.5, hence on a relative basis, it is better to use country-specific bond funds rather than stock funds to create currency
overlays in one’s portfolio.

When targeting the currency asset class, investors may base their portfolio revisions on various models of currencies,
interest rates and equity markets to determine the fundamental fair value of various currencies. Proprietary models (e.g.
based on various parity conditions) may be used to quantify the degree of over or under-valuation for a particular pair of
currencies. Fundamental factors may be analyzed that help gauge the demand for goods and assets between two countries.
Technical factors may be used to gauge the prevailing trend of a currency pair. In the FX market, the best forecast for a
future movement in the exchange rate is its past trend. Hence, the best empirical estimate of the future return is the
mean return estimated over the past data.

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Global Investment Philosophy

To use currency as an asset class, investment managers believing in a global investment philosophy should resort to
market timing to temporarily increase or reduce their exposure in one or more markets or currencies as a short term
trading tactic (as opposed to long-run strategies for allocating assets). They may also actively manage their currency
position using derivatives. Active asset allocation management may be achieved using national index funds for each
market. I suggest treating currencies not as residual variables, and currency risk not as a necessary evil. Since currency
movements were shown to be predictable above, they should not hedge foreign portfolios. Instead, they should take a
more proactive approach to currency forecasting. They should try to minimize the contribution made by currencies to
total risk, while cashing in on opportunities created by currency movements.

As another approach, a global money manager might do currency overlays. Currency overlay managers do not manage
the existing underlying portfolio itself. They take currency positions by just using currency derivative overlays on the
composition of a portfolio managed by another party on a daily basis. With their active long/short currency bets,
currency overlay managers can provide the alpha available from using currencies as a separate asset class.

Conclusion
Portfolio asset allocation should consider currency as a distinct target asset class to optimize risk-adjusted returns on a
global basis. There is a non-zero expected return available in currencies that can be realized by taking active currency
bets. Specific currency investment processes and portfolio rebalancing mechanisms described above may be used to
achieve investment objectives.

References:

[1] Jorion, Philippe Asset Allocation with Hedged and Unhedged Foreign Stocks and Bonds, Journal of Portfolio
Management, 1989
[2] Perold and Schulman: The Free Lunch in Currency Hedging Implications for Investment Policy and Performance
Standards,” Financial Analysts Journal, May-June 1988, 45-50
[3] Solnik and McLeavey International Investments
[4] Brinson, Brown and Beebower, "Determinants of Portfolio Performance", Financial Analysts Journal (July-August
1986) pp. 39-44.
[5] Odier, Solnik: Lessons for International Asset Allocation, Financial Analysts Journal, 1993

APPENDIX:

The table below is from Perold: Table below from Jorion:

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Figures below are from Solnik[5]:

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