Optimal Currency Exposure When Interest Parity Fails

Most institutional investors view foreign-exchange risk primarily as a problem to be hedged. This paper challenges that conventional wisdom by demonstrating that currency exposure can play a broader role in strategic asset allocation, portfolio construction, and risk management.

The authors examine how investors should manage currency risk when one of the foundational assumptions of international finance, interest parity, does not hold consistently in practice. Using a portfolio optimization framework and evidence from global financial markets, they show that optimal currency exposures depend not only on minimizing risk, but also on understanding the interaction between currency risk premia, asset returns, and diversification benefits.

For pension funds, insurers, sovereign wealth funds, endowments, and asset managers, the findings suggest that currency management should be integrated into strategic asset allocation and risk-budgeting decisions rather than treated as a separate operational function. Policies that rely on fixed or mechanical hedging rules may overlook opportunities to improve portfolio resilience or may create unintended exposures.

For regulators, central banks, and policymakers, the paper highlights how developments in international capital markets can affect the transmission of risk across countries and financial systems. As geopolitical fragmentation, monetary-policy divergence, and global economic uncertainty increase, understanding currency exposures becomes increasingly important for assessing financial resilience and cross-border vulnerabilities.

The broader lesson is that currency risk is not simply a technical implementation issue. It is a strategic consideration that sits at the intersection of investment management, global financial integration, and institutional resilience.