International Diversification Benefits with Foreign Exchange Investment Styles

Style-based investments and their role for portfolio allocation have been widely studied by researchers in stock markets. By contrast, there exists considerably less knowledge about the portfolio implications of style investing in foreign exchange markets. Indeed, style-based investing in foreign exchange markets is nowadays very popular and arguably accounts for a considerable fraction in trading volumes in foreign exchange markets. This study aims at providing a better understanding of the characteristics and behavior of stylebased foreign exchange investments in a portfolio context. We provide a comprehensive treatment of the most popular foreign exchange investment styles over the period from January 1985 to December 2009. We go beyond the well known carry trade strategy and investigate further foreign exchange investment styles, namely foreign exchange momentum strategies and foreign exchange value strategies. We use traditional mean-variance spanning tests and recently proposed multivariate stochastic dominance tests to assess portfolio investment opportunities from foreign exchange investment styles. We find statistically significant and economically meaningful improvements through style-based foreign exchange investments. An internationally oriented stock portfolio augmented with foreign exchange investment styles generates up to 30% higher return per unit of risk within the covered sample period. The documented diversification benefits broadly prevail after accounting for transaction costs due to rebalancing of the style-based portfolios, and also hold when portfolio allocation is assessed in an out-of-sample framework.

Kröncke, Tim-Alexander, Felix Schindler and Andreas Schrimpf (2011), International Diversification Benefits with Foreign Exchange Investment Styles, ZEW Discussion Paper No. 11-028, Mannheim.