Asset Allocation

nvestors create global bond portfolios for a variety of reasons: to diversify interest rate risk, to manage yield, to control exposure to foreign currencies, and to enlarge the universe of possible trading opportunities. This article describes a new approach to international asset allocation of fured-income securities. We show how to construct portfolios by choosing the optimal weights to invest in assets in each country and the optimal degree of hedging of currency exposure, given the investor's views for interest rates and exchange rates. While our approach brings several new features to the traditional asset allocation problem, its most innovative contribution is to allow investors to compare their outlook for currencies and interest rates with expected returns generated by an International Capital Asset Pricing Model (ICAPM) equilibrium. The simple idea that expected returns ought to be consistent with market equilibrium, except to the extent that the investor explicitly states otherwise, turns out to be of critical importance in making practical use of the model. In particular, it allows investors to specifj views in a much more flexible way than otherwise would be permitted. For example, rather than requiring investors to specify views about absolute returns on every asset, our approach allows investors to specifj as many or as few views as they wish views with different degrees of confidence and views about relative returns on different assets. This use of the expected returns associated with asset market equilibrium as a reference point for investors is a unique feature of the model. Much of our article focuses on this aspect of our approach.' Another advantage to our approach is that it jointly determines the optimal allocations of bonds into differI