Portfolio Adjustment Costs: A New Lens on Currency Market Dynamics and Returns

The study by Bas B. Bakker from the IMF highlights portfolio adjustment costs, rather than risk aversion, as the primary driver of systematic patterns in currency markets. Using data from advanced economies, it reveals how these costs explain deviations from Uncovered Interest Rate Parity and predict long-term excess returns.

In a groundbreaking study from the International Monetary Fund’s Western Hemisphere Department, Bas B. Bakker challenges long-standing economic assumptions about non-zero-expected excess returns in currency markets. Bakker introduces a simpler and empirically robust explanation centered on portfolio adjustment costs traditionally attributed to time-varying risk premiums demanded by risk-averse investors. This framework builds on the work of Bacchetta and van Wincoop from the University of Lausanne and the University of Virginia, highlighting how frictions in portfolio adjustments, rather than investor risk aversion, drive systematic deviations from Uncovered Interest Rate Parity (UIP). These findings reshape the understanding of currency market behavior, offering a clearer, testable alternative to complex risk-aversion theories.

Evidence from Advanced Economies

Drawing on data from nine advanced economies with inflation-targeting regimes and floating exchange rates, the study analyzes currency markets from 2000 to 2024. The evidence reveals persistent deviations from UIP, which predicts that interest rate differentials should be offset by currency movements, leaving no room for excess returns. Instead, Bakker finds that currencies with higher interest rates often fail to depreciate as expected, yielding systematically positive excess returns. These deviations are attributed to frictions such as transaction costs, liquidity constraints, and institutional barriers that hinder immediate portfolio reallocation. These adjustment costs generate predictable patterns in exchange rate movements and returns, challenging the traditional focus on risk-aversion-driven explanations.

Portfolio Adjustment Costs vs. Risk Aversion

Bakker’s findings show that portfolio adjustment costs explain observed currency market behaviors better than risk-aversion models. A key insight is the negative correlation between exchange rate levels and long-term expected excess returns. For example, higher exchange rate levels often signal lower future returns, a relationship that contradicts traditional models predicting the opposite. Similarly, Bakker uncovers a strong positive correlation between expected exchange rate changes and expected excess returns, further deviating from risk-aversion models that anticipate a negative relationship. These findings align closely with the predictions of the portfolio adjustment costs framework, offering a simpler and empirically validated explanation.

To test alternative hypotheses, Bakker examines whether risk premium shocks, often linked to market stress, could account for these patterns. While periods of high market volatility, measured by the VIX index, align with increased excess returns, these shocks are too infrequent to explain the systematic relationships observed in the data. Furthermore, even during low-volatility periods, the negative link between exchange rate levels and expected excess returns persists, underscoring the dominant role of adjustment costs. Other potential explanations, such as intermediary constraints or noise trader activity, are similarly insufficient as they rely on complex and often unobservable mechanisms, unlike the straightforward and testable portfolio adjustment costs framework.

Long-Term Predictability in Currency Markets

One of the most striking findings is the predictability of excess returns over longer horizons. Bakker demonstrates that one-year expected excess returns strongly predict multi-year returns, with the strength of the relationship increasing over time. For instance, five-year returns are often three to four times larger than one-year expectations. This long-horizon predictability is rare in financial markets and challenges conventional wisdom. Currencies like the euro and Swiss franc show high levels of predictability, with multi-year returns explaining a significant portion of observed variations. These findings mirror earlier results on exchange rate changes and suggest a unified framework for understanding currency market dynamics across time horizons.

By decomposing exchange rates into long-term stochastic trends and short-term cyclical components, Bakker offers a nuanced understanding of market behavior. The stochastic trend captures persistent shifts in exchange rates, while the cyclical component reflects temporary deviations driven by adjustment costs. This decomposition highlights how frictions prevent immediate portfolio rebalancing, leading to predictable patterns in excess returns that align closely with the portfolio adjustment costs framework.

Implications and Future Research

Bakker’s findings have significant implications for both theory and practice. They challenge the dominance of risk-aversion-based models, which often rely on complex, unobservable factors such as intermediary constraints or noise trader behavior. Instead, the study highlights the simplicity and empirical validity of portfolio adjustment costs as a primary driver of deviations in currency markets. For policymakers and investors, these insights offer actionable tools to better understand currency market dynamics. For example, recognizing how institutional features like transaction costs or regulatory barriers influence adjustment costs could help optimize portfolio strategies or mitigate risks.

The study also raises broader questions about the role of adjustment costs in other asset classes, such as equities, bonds, or commodities. Future research could explore whether similar frictions affect these markets or investigate the precise sources of portfolio adjustment costs. Whether they stem from institutional features, market microstructure, or behavioral factors, understanding their origins could deepen insights into financial market functioning.

Redefining Currency Market Dynamics

Bakker’s work represents a paradigm shift in understanding currency markets. By emphasizing the role of portfolio adjustment costs, the study offers a testable and intuitive alternative to traditional theories centered on risk aversion. It provides empirical evidence that these adjustment costs, rather than risk premium shocks or intermediary constraints, are the key to explaining deviations from UIP and the systematic behavior of expected excess returns. Moreover, the predictability of excess returns over long horizons challenges conventional market theories and underscores the practical relevance of Bakker’s findings. This research not only reshapes academic discourse but also provides valuable guidance for policymakers, investors, and market participants navigating the complexities of global currency markets. With its simplicity and empirical rigor, the portfolio adjustment costs framework marks a significant advancement in the study of international finance, paving the way for future exploration across asset classes and financial systems.