Faculty Scholarship 1994 - Present

The Role of Foreign Currency Investment in a Global Equity Portfolio

Historically, currency investment used to be the domain of a relatively small group of foreign-exchange traders as compared with the number of equity investors worldwide. In recent years, hedge funds have contributed to the rise of currency investment. There is also a wider acceptance among traditional money managers, who are adding foreign-currency exposure to pension funds, trusts, and endowment (Vames 2006). Lipper Inc. reports a doubling in six months to $1.4 billion of assets invested in hard-currency mutual funds and exchange-traded funds near the end of 2006 (Coleman 2006). Some pension funds are known to allocate 5 percent of their portfolios to alternative assets such as currency (Martin 2006). In addition to recent interest by hedge funds, foreign currency is gaining acceptance by a small number of traditional investors as well (Martin and Vames 2005). Some private investment managers recommend an allocation range of 3-8 percent of a portfolio to money-market-type investments in foreign currencies (Laise 2006). Given the evolution of investing, individuals have a number of ways to take currency positions, including opening foreign currency bank accounts or investing in derivatives, foreign certificates of deposit, or in the growing number of mutual funds and ETFs now taking positions in foreign currency. The purpose of this study is to assess the benefit of including foreign currency as an investment asset in a portfolio of U.S. and foreign equities from 1975 to 2006. As the integration of global markets continues, investors can potentially reduce their portfolio risk by expanding their asset search to identify assets that have relatively low correlation with U.S. stocks. We demonstrate that the low correlation of foreign currency with the U.S. stock market can potentially provide such portfolio risk reduction. A portfolio optimization model is used to evaluate the risk and return of adding currency holdings to a global U.S.-based equity portfolio. While an unconstrained portfolio invested exclusively in foreign equities benefits significantly from the introduction of foreign currency, foreign currency investment provides only a small long-term potential benefit to investors who maintain a substantial portion of their assets in U.S. equities.