Beyond the carry trade: Optimal currency portfolios

Author's Pre-print

We test the relevance of technical and fundamental variables in forming currency portfolios. Carry, momentum and value reversal all contribute to portfolio performance, whereas the real exchange rate and the current account do not. The resulting optimal portfolio produces out-of- sample returns that are not explained by risk and are valuable to diversified investors holding stocks and bonds. Exposure to currencies increases the Sharpe ratio of diversiÖed portfolios by 0.5 on average, while reducing crash risk. We argue that besides risk, currency returns reáect the scarcity of speculative capital.