International Portfolio Optimisation with Integrated Currency Overlay Costs and Constraints

Portfolio optimisation typically aims to provide an optimal allocation that minimises risk, at a given return target, by diversifying over different investments. However, the potential scope of such risk diversification can be limited if investments are concentrated in only one country, or more specifically one currency. Multi-currency portfolio is an alternative to achieve higher returns and more diversified portfolios but it requires a careful management of the entailed risks from changes in exchange rates. The deviation between asset and currency exposures in a portfolio is defined as the “currency overlay”. This paper addresses risk mitigation by allowing currency overlay and asset allocation be optimised together. We propose a model of the international portfolio optimisation problem in which the currency overlay is constructed by holding foreign exchange rate forward contracts. Crucially, the cost of carry, transaction costs, and margin requirement of forward contracts are also taken into account in portfolio return calculation. This novel extension of previous overlay models improves the accuracy of risk and return calculation of portfolios; furthermore, our experimental results show that inclusion of such costs significantly changes the optimal decisions. Effects of constraints imposed to reduce transaction costs associated are examined and the empirical results show that risk-return compensation of portfolios varies significantly with different return targets.