Optimal Currency Exposure When Interest Parity Fails

Abstract

This article examines optimal currency exposure for US and Canadian equity and bond investors across developed and emerging markets from 1975–2023. The US dollar and, to a lesser extent, the euro behave as reserve currencies that tend to appreciate when global equity markets fall, while the currencies of commodity-producing economies and emerging-markets economies tend to depreciate. Accordingly, investors should seek exposure to the US dollar and the euro and hedge exposure to commodity-producer and emerging-markets currencies from a portfolio-risk minimization perspective. Realistic hedging costs in the form of deviations from covered interest parity do not alter this conclusion. However, persistent deviations from uncovered interest parity generate significant positive expected returns for emerging markets currencies which can attenuate and even reverse the portfolio-risk minimization hedging positions. Optimal currency exposure therefore reflects both diversification benefits and currency risk premia, implying that effective currency policy requires balancing risk reduction against return enhancement.