International diversification benefits with foreign exchange investment styles

Abstract

Style-based management of the foreign exchange (FX) component of international investments with carry trade, FX momentum, and FX value strategies provides economically large and significant diversification benefits. These speculative benefits go beyond the hedging benefits of FX risk documented in the earlier literature. Our results hold after transaction costs and are confirmed in an extensive out-of-sample experiment mimicking investor decisions in real time. Adding a composite FX style portfolio to diversified allocations of global bonds and stocks leads to a 64% increase in the out-of-sample Sharpe ratio from 0.64 to 1.05, without adverse impact on other portfolio characteristics such as skewness.