Currency plays an interesting role in investing. Some consider it a useless source of risk as it bears no risk premium; hence it dilutes international returns and therefore needs to be hedged. Others consider currency an asset class in its own right due to the structure in the currency movements. The consensus seems to be that both is true; it is a tactical asset class that should be strategically hedged.

This has led to the adoption by institutional investors of currency overlay management programs in the 1980s. In the early nineties the CFA Institute sponsored research by Denis Karnosky and Brian Singer aimed at providing a comprehensive analytical framework for measuring currency decisions.

In practice, however, the Karnosky & Singer model has proved to be very difficult to apply, especially if the market and currency decisions are made by different managers. In this paper we propose to extend the model to make it especially suitable for institutional investment portfolios.

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