Practical Financial Optimization: Decision Making for Financial Engineers

Chapter 10

International Asset Allocation

10.1 Preview

Portfolio managers in the international markets must address jointly the market price risk in each market and the currency risk across markets. International asset allocation diversifies market risk, but increases the exposure to currency risks. In this chapter we develop models for integrating the asset allocation decisions with appropriate hedging strategies, thus managing market and credit risk in an integrated fashion. The effectiveness of the models is investigated empirically in different settings. Results show that the optimal hedging strategies depend on the investors' perspective, i.e., asset classes and currency denomination. The models, however, are general and can generate a range of optimal strategies: from complete to partial hedging or selective hedging.

10.2 The Risks of International Asset Portfolios

Does international diversification pay? This question has been answered affirmatively since the 1960s. International markets seemed sufficiently uncorrelated at that time, so that portfolio risks could be reduced by a well-diversified international portfolio, even when accounting for the currency risk exposure. This observation held true for both the equities and fixed-income markets.

Today, however, a black-or-white answer to this question is no longer acceptable, since many interrelated factors need to be considered. For instance, the volatilities of the fixed-income markets – especially bond markets – are typically ...