The main idea contained in the currency portfolio theory is that a set of currency pairs with different risk and return have a higher performance and a lower risk compared to that obtained by trading in a single currency. The goal of currency portfolio diversification is to obtain the opportunities that trading in single currencies cannot offer.
To fully understand the advantage of a well-diversified portfolio, we need to introduce the concept of correlation, that is, the tendency of two currency pairs to move in the same direction. The goal, in fact, in building an excellent currency portfolio is to put together several pairs related to each other. The calculation of the correlation coefficient between the various pairs that make up a portfolio also determines the degree of risk involved. The goal for a trader is always to obtain a higher return than the reference market benchmark in a given medium-long term time horizon.
The correlation can be positive if both pairs move in the same direction (for example, both pairs rise or fall), negative if one currency moves in one direction and the other in the opposite direction (for example, one security goes down and the other goes up).
The unwritten rule for obtaining an excellent currency portfolio diversification is that the greater the number of pairs used, the greater the probability of beating the reference benchmark. It is important that the pairs are not correlated with each other or as least as possible, because in this way the return of the components of the portfolio moves independently.
Diversifying means evaluating the correlation between currencies and the market scenario and choosing a defined time horizon to obtain the result. A good currency portfolio can also be built from a few well-selected pairs. Diversifying means knowing how to choose pairs based on risk and return targets.
On an operational level, the basic rule that a trader must follow is the following: the greater the capital invested in different currency pairs, the greater the benefit, in terms of less risk, that is obtained. To do this, it is necessary to take into account the degree of correlation between the pairs making up the investment, also based on a chosen time horizon.
The goal in risk diversification is to better balance the portfolio, by inserting currency pairs with positive returns to cancel out the negative returns of others, thus reducing the total portfolio risk. Risk assesment must be placed at the center of the decision-making process. The guiding principles are as follows. The diversification effect reduces the risk only if the chosen pairs are not positively correlated. The currency portfolio must include a sufficient number of unrelated pairs. In this regard, it is good to remember that the risk of the portfolio may approach zero, but it will never be completely zero. In order to build a well diversified portfolio, we must also take into account the so-called multiple risks, which are all sources of risk related to the forex market.
In addition to risk, another key variable to obtain correct diversification is the investment time horizon. This is based on the following characteristics. Each portfolio choice involves a drawdown, or a descent from the maximum value hit by a currency pair to its minimum, in a given period of time and the calculation of the relative recovery times. The variance in the returns of a currency investment decreases with the length of the investment period and converges towards the long-term average return. The lengthening of the time horizon reduces the risk of loss and allows you to invest in riskier pairs. The total time needed to return to a tie since the start of the drawdown phase is called “underwater”.
In conclusion, in choosing currency pairs for obtaining a well diversified portfolio, the contribution that these can supply to the overall risk and the total return of the portfolio counts. For this reason, even a risky pair may be suitable for balancing a portfolio built on a long-term goal.