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Optimal and Naive Diversification in Currency Markets


Ackermann, Fabian; Pohl, Walt; Schmedders, Karl (2016). Optimal and Naive Diversification in Currency Markets. Management Science, 63(10):3347-3360.

Abstract

DeMiguel et al. [DeMiguel V, Garlappi L, Uppal R (2009) Optimal versus naïve diversification: How inefficient is the 1/N portfolio strategy? Rev. Financial Stud. 22(5):1915–1953] showed that in the stock market, it is difficult for an optimized portfolio constructed using mean-variance analysis to outperform a simple, equally weighted portfolio because of estimation error. In this paper, we demonstrate that portfolio optimization can be made to work in currency markets. The key difference between the two settings is that in currency markets interest rates provide a predictor of future returns that is free of estimation error, which permits the application of mean-variance analysis. We show that over the last 26 years, a mean-variance efficient portfolio constructed in this fashion has a Sharpe ratio of 0.91, versus only 0.15 for the equally weighted portfolio. We also consider the practical implementation of this strategy.

Abstract

DeMiguel et al. [DeMiguel V, Garlappi L, Uppal R (2009) Optimal versus naïve diversification: How inefficient is the 1/N portfolio strategy? Rev. Financial Stud. 22(5):1915–1953] showed that in the stock market, it is difficult for an optimized portfolio constructed using mean-variance analysis to outperform a simple, equally weighted portfolio because of estimation error. In this paper, we demonstrate that portfolio optimization can be made to work in currency markets. The key difference between the two settings is that in currency markets interest rates provide a predictor of future returns that is free of estimation error, which permits the application of mean-variance analysis. We show that over the last 26 years, a mean-variance efficient portfolio constructed in this fashion has a Sharpe ratio of 0.91, versus only 0.15 for the equally weighted portfolio. We also consider the practical implementation of this strategy.

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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Business Administration
Dewey Decimal Classification:330 Economics
Language:English
Date:15 August 2016
Deposited On:16 Mar 2018 07:26
Last Modified:13 Apr 2018 11:41
Publisher:Institute for Operations Research and the Management Science
ISSN:0025-1909
OA Status:Closed
Publisher DOI:https://doi.org/10.1287/mnsc.2016.2497
Other Identification Number:merlin-id:16098

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