Exchange Rate Forecasting and the International Diversification of Liquid Asset Holdings

Abstract

The gains from diversifying portfolios internationally rather than restricting investment choices solely to domestic assets are well established. (See, e.g., Grubel 1968; Levy-Sarnat 1971; and Lessard 1975 among others.) Although initial studies focused on long-term investments in stocks or bonds, the possibilities for diversifying portfolios of noninterest-bearing currencies or highly liquid interest-bearing assets have also been studied (Levy-Sarnat 1978, 1983 and Levy 1981). The latter studies have been motivated by referring to the working capital positions. of multinational corporations, although they ignore currency-specific transactions involving accounts receivable and accounts payable that are important in properly distinguishing between firms' perfectly hedged positions and open "speculative" positions in the foreign exchange markets. An alternative interpretation might focus on the activities of private investors. In this context, however, the one-period utility maximizing framework where utility depends solely on end-of-period wealth and not on consumption decisions over time may be objectionable.