Effect of exchange rate and interest rate risk on international fixed-income portfolios

The purpose of this study was to investigate empirically the effect of interest rate and currency risk on international currency and fixed-income security allocation during the period of 1983 through 1988. It is shown that bonds of various maturities have different characteristics and cannot substitute for one another in an international portfolio. Among these characteristics, the correlation between the foreign and domestic bond returns and between foreign bonds and exchange-rate returns are significantly lower for long-term than for short-term bonds. Consequently, in some cases, it may be more efficient to increase portfolio expected return by altering the duration of the bonds rather than by increasing the foreign position of the portfolio. A comparison of foreign exchange hedge with the unhedged strategies further emphasizes the different roles of short-term and long-term bonds in internationally diversified portfolios.