Performance of Currency Portfolios Chosen by a Bayesian Technique: 1967-1985

The hypothesis being tested in this article is that participants in the foreign exchange market are improperly diversified across currencies. If this type of inefficiency were to be verified, it could constitute an explanation of the large volatility of exchange rates: traders who do not fully exploit the potential for diversification unnecessarily restrict the sizes of the positions they do take in the individual currencies, generate thereby a shortage of speculative interest, and, as a consequence, stabilize exchange rates less than they otherwise would. In order to test the hypothesis, a number of implementable portfolio diversification policies are tried out on a large body of data covering nine major currencies and eighteen years of weekly observations. While some policies do produce abnormal returns (over and beyond proper reward for risk), none does so in a statistically significant way. This means that the evidence does not allow one to conclude that market participants are improperly diversified. As a byproduct of this investigation, techniques are found which would allow portfolio managers to earn a proper reward for risk by following a purely mechanical procedure; such techniques may be valuable in a multi-country world where the aggregate portfolio of currencies and securities is unknown and is not supposed to be efficient.