Revisit the Cross-Country Asset Allocation in Portfolio Choice

Abstract

In this study, we review the investment choice problem in international portfolio management for long-term investors (i.e., institutional investors, asset managers, financial planners, and wealthy individuals) where, in particular, the exchange rate risk and the interest rate risk are incorporated. While the theoretical literature has made significant development, the case with exact solution are still relatively few. Starting with the new perspective in Lioui and Poncet (2003), they show that the optimal portfolio can be divided into three parts: the international speculative portfolio, the domestic interest rate hedging portfolio and the cross-country interest rate differential hedging portfolio. Since the second hedging component presented in Lioui and Poncet (2003) is an indirect solution, we adopt a specific case that all diffusion coefficients in the dynamics of the state variables is constant to clarify the hedging implications. The results show that the optimal strategy follows a four-fund separation theorem and the number of the funds is irrelevant to the amount of the assets. For non-myopic investors, the currency risk-hedging component will not vanish due to the Purchase Power Parity (PPP) deviation and the hedging demand becomes smaller when the investors shorten his time horizon.