Exchange Rate Forecasting and the International Diversification of Liquid Asset Holdings
1983 (English)Report (Other academic)
This paper re-examines the potential gains from diversifying liquid asset holdings internationally. In particular, it recognizes the fact that international investors must forecast the expected returns and evaluate the exchange risks associated with foreign assets before the optimum diversified portfolio can be selected. Using three possible forecasting techniques (the martingale, submartingale, and forward rate models), we conclude that the warranted degree of international diversification, in terms of the number of assets that should be held, is quite limited. Furthermore, the expected ex ante return from undertaking such diversifiation is not large. It is in the range of two to four percent per quarter depending on the associated risk according to the ex ante efficiency frontiers.
More importantly, the actual returns received by investors who diversified optimally ex ante were invariably less than the investor anticipated. The implication is that investors are not being adequately compensated (in terms of realized returns) for the risks they incur in diversifying their liquid asset portfolios internationally. The use of ex post data in previous studies of the gains from international portfolio diversification may result in an overestimation of the benefits that are likely to be reaped relative to the associated foreign exchange risks. This is, in large part, due to the extreme difficulty in making accurate exchange rate forecasts in the volatile floating-exchange-rate environment of the post-Bretton Woods era.
Place, publisher, year, edition, pages
Stockholm: IIES , 1983. , 58 p.
Seminar Paper / Institute for International Economic Studies, Stockholm University, ISSN 0347-8769 ; 245
IdentifiersURN: urn:nbn:se:su:diva-41475OAI: oai:DiVA.org:su-41475DiVA: diva2:330434
Published in connection with a visit at the IIES2010-07-152010-07-152010-07-15