Currency as an Asset Class and Black-Litterman

I was recently asked a question regarding how to integrate currency as an Asset Class into the Black-Litterman model. This raises several interesting questions. I am hoping this post answers a few, rather than making it more murky.

I am of the opinion that currency is not an asset class. Here are some ideas in that direction.

I do not believe that institutional investors consider currency as a separate asset class. They do often seem to segregate hedge fund investments as if they are a separate asset class, and may place currency managers there. Check out the asset allocations of major endowments for example, I don't recall seeing one with currency called out as a separate asset class.

Within the initial Black-Litterman papers, they considered a global equilibrium that was partially hedged and thus considered currency in this light. It was not considered a separately investable asset class. You essentially hold currency along with the assets denominated in them.

When using a model like Black-Litterman and the CAPM market model, an asset class market capitalization does not include derivatives, only what we might call the cash market. In F/X, as an asset class this might mean holding a basket of currencies as an asset, but you would want to at least earn a deposit rate on the currency which means rather than a currency investment, we could look at it as a basket of short term bonds.

Finally, the criteria for identifying something as an asset class is that they should be homogenous, mutually exclusive, diversifying, contribute to a the market cap and capable of absorbing liquidity. Currency meets most of those criteria, except for being mutually exclusive. If we desire foreign equities to be an asset class, and currency as well then we need to use the hedged foreign equities as our asset class, but that is really just a long position in foreign equity and a short position in the currency. The CAPM equilibrium model in the original Black-Litterman paper deals with this type of model where currency hedging is included in the model, but currency is not an asset class.

For further information, there are some papers linked to from the site which consider issues of whether commodities are an asset class and how to compute their market cap, and also a similar paper dealing with real estate.

I have not found any similar papers discussing currency as an asset class on the internet as of this time, but I haven't searched exhaustively.