Maximally Predictable Currency Portfolios

We investigate the predictability of the G10 currencies with respect to lagged currency returns from the perspective of a U.S. investor using the maximally predictable portfolio (MPP) approach of Lo and MacKinlay (1997). We show that, out-of-sample, the MPP yields a higher Sharpe ratio, higher cumulative return and lower maximum drawdown than both a naïve equalweighted portfolio of the currencies and an equal-weighted portfolio of momentum trading strategies, and that a mean-variance investor would be willing to pay a performance fee to switch from the naïve and momentum portfolios to the MPP. The MPP has performed particularly well since the 2008 financial crisis, in contrast with the momentum portfolio, the value of which declined significantly over this period. Our results are robust to the estimation window length, the type and level of portfolio weight constraints and transaction costs.