The purpose of this study is to investigate the ex ante benefits of international diversification to an Australian investor through the use of methods which attempt to control for currency risk and estimation risk.
The two methods used to control for currency risk are multicurrency diversification, and hedging through the use of forward foreign exchange contracts. Estimation risk is controlled through the use of different portfolio selection strategies. The three portfolio selection strategies used to control for estimation risk are the Equally Weighted strategy, the Minimum Variance strategy and the James-Stein Tangency strategy. A fourth portfolio selection strategy used in this study is the classical Markowitz Tangency strategy For each of these strategies both hedged and unhedged portfolios were constructed.
Eight portfolios in all were formed using weekly national stock market index data and wholesale spot exchange rates. The data was collected for eight countries over the period of November 1987 through May 1991. A method of correcting for serial and cross correlation was applied to this data prior to constructing the portfolios. The performance of these portfolios was evaluated on the basis of both their Sharpe measures and a basic dominance analysis.
The results of this study showed that the hedged portfolios outperformed their unhedged counterparts both in terms of Sharpe measures and dominance analysis. The portfolios which performed the best were the hedged James-Stein and (classical) Tangency portfolios. Next in performance came the hedged Equally Weighted and Minimum Variance portfolios, then the unhedged Equally Weighted and Minimum Variance portfolios, and the worst performing portfolios were the unhedged James-Stein and (classical) Tangency portfolios. The results of controlling for estimation risk were not conclusive since no distinction could be drawn between the performances of the James-Stein and (classical) Tangency strategies. A very general appraisal of the method used to correct for serial and cross covariance was also presented.