International Portfolio Management, Currency Risk and the Euro

We investigate the impact of currency risk and the adoption of the euro on the international portfolio choices. We use a parsimonious GARCH parameterization to estimate a conditional version of the International Capital Asset Pricing Model and generate out of sample forecasts of assets returns and market and currency risk exposures. We implement out of sample dynamic asset allocation strategies that take advantage of the predictability and time varying nature of both risk exposures and risk premiums. We find that strategies that include equities and currencies significantly outperform strategies that exclude currencies. Further most of the benefits accrue from managing non-EMU currency exposures. This suggests that the portfolio trade-offs for international investors are unlikely to drastically altered by the introduction of the euro.