Global asset allocation in fixed income markets

Many global investors are faced with the problem of choosing an appropriate currency allocation of their assets in the capital markets. This paper addresses the asset allocation problem under the assumption that the investment universe is comprised of unhedged risk-free bonds in different countries. In general, the total return arising from holding an unhedged bond portfolio is comprised of two components. One component of the return arises from the bond price changes resulting from yield curve movements and the other component arises from exchange rate fluctuations. In this paper, bond price changes are assumed to be governed by a one factor interest rate term structure model. The return arising from exchange rate changes is extracted by modelling the evolution of exchange rates as a jump stochastic process. The jump process is assumed to occur in the volatility of exchange rate returns. This model is consistent with the empirical evidence that the volatility of currency returns exhibits GARCH behaviour. Using the models that describe the evolution of interest rates and exchange rates, the optimal portfolio allocation problem is solved in a mean-variance setting by Monte Carlo simulation. The out-of-sample performance of the portfolios selected is also presented and is compared against those obtained using other existing methods.