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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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15.3 The Economic Value of Volatility and Correlation Timing

15.3.1 The Dynamic Strategy

We design an international asset allocation strategy that involves trading the US dollar and four other currencies: the British pound, Deutsche mark/euro, Swiss franc, and Japanese yen. Consider a US investor who builds a portfolio by allocating her wealth between five bonds: one domestic (US) and four foreign bonds (UK, Germany, Switzerland, and Japan). The yield of the bonds is proxied by euro deposit rates. At the beginning of each period, the foreign bonds yield a riskless return in local currency but a risky return in US dollars. Hence the only risk the US investor is exposed to is the FX risk. Every period the investor takes two steps. First, she uses each model to forecast the one-day-ahead conditional volatilities and correlations of the exchange rate returns. Second, conditional on the forecasts of each model, she dynamically rebalances her portfolio by computing the new optimal weights that maximize utility. This setup is designed to inform us whether using one particular conditional volatility and correlation specification affects the performance of an allocation strategy in an economically meaningful way.

15.3.2 Dynamic Asset Allocation with CRRA Utility

We set up a dynamic asset allocation framework with CRRA utility for assessing the economic value of strategies that exploit predictability in volatilities and correlations. Consider the portfolio choice at time t of an investor ...

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