How can one diversify in the currency market?

The question of currency market diversification is one that seems to come up on a fairly regular basis. For example, this query was posted during a recent webinar:

Looking at currency as a longer term alternative to cash, how many different currencies would you recommend to maintain adequate diversification??

From a trading perspective

In trading terms, the limited number of major currencies puts serious constraints on how many pairs you can reasonably have positions in before you start having correlation issues (yes, you could mix in the more regional currencies, but since they are primarily traded either against the USD or the EUR they won't help much). Basically, any two pairs which share a common element, such as EUR/USD and USD/JPY, are going to tend to be quite correlated. If you're looking to be diversified you wouldn't want to hold both pairs, unless you cut the size of each to account for the singular USD risk represented.

So if you avoid having any one currency in multiple pairs, sticking with just the majors, you'd only be able to hold four pairs at a time. They might look something like USD/CAD, EUR/CHF, GBP/JPY, and AUD/NZD. Even then you're bound to find times when one or more of those pairs are correlated in some fashion because similar events are driving them. For example, in a strongly risk averse market USD/CAD and GBP/JPY could be highly negatively correlated.

From an investing perspective
Now, if you're an investor aiming to diversify your holdings you'll look at things in a slightly different way. You're not thinking in trading pairs anymore. Instead you should be thinking in terms of having your money in the currencies of countries or regions which are not closely linked economically to your own, meaning they don't tend to move in a common direction for the same reasons. For example, the Mexican economy is closely tied to the US. As a result, the MXN tends to trade on US developments. That might not make it such a good diversification currency for a US investor, but it could be a reasonable option for an Aussie.

In a like manner, think also of the commonalities shared between different currencies. For example, the so-called commodity currencies have a common tendency to react in a similar fashion to moves in the commodity markets. That means a Canadian investor probably wouldn't want to hold a lot of AUD, but might find the JPY a good choice.

The best way to frame the diversification decision is to start by thinking about the major economic drivers of the value of your home currency. Then, look for currencies which are driven more by other factors. This requires a fair bit of research and understanding of fundamentals. It's not to be taken lightly. Most investors are probably better off just sticking to their home currency, since that's where there expenses moving forward will be.

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