Currency Investing: A Risk Premium Approach

Aysu Secmen, Charles Wu and Pierre-Alexandre Noual

The asset allocation decision is one of the key decisions an investor has to make. Although the concept of diversification is simple, portfolios often end up unbalanced and unable to perform robustly across different macro environments. We have witnessed a significant increase in the discussions around the topic of asset allocation by both practitioners and academics. These discussions were fuelled by the poor performance of traditional portfolios during the global financial crisis and the realisation that true diversification was at best elusive, and at worst absent exactly when investors needed it. As a result, portfolio construction came under close scrutiny, not only in terms of allocation concepts, but also for the universe of assets and building blocks.

This chapter will first review the traditional asset allocation paradigm, where equity market risk overwhelmingly dominates in terms of contribution to portfolio risk. It then moves on to describe an increasingly relevant paradigm for asset allocation, centred around the concept of risk premia. Indeed, investors find it increasingly meaningful to think of assets as bundles of exposures to various risk factors, from which they