Development and Evaluation of a Portfolio Selection Model and Investment Algorithm in Foreign Exchange Market

In this paper, we develop a portfolio selection model that can be used to invest in markets with margin requirements such as the foreign exchange market. An investment algorithm to implement the proposed portfolio selection model based on objective historical data is also presented. We furthe r conduct empirical analysis on the performance of a hypothetical investment in the foreign exchange market, using the proposed portfolio selection model and investment algorithm. Using 7 currency pairs that recorded the highest trading volume in the foreign exchange market during the most recent 10 years, we compare the performance of 1) the Dollar Index, 2) a 1/N Portfolio which equally allocates capital to all N assets considered for investment, and 3) a hyp othetical investment portfolio selected and managed according to the portfolio selection model and investment algor ithm proposed in this paper. Performance is compared in terms of accumulated returns and Sharpe ratios for the 10-ye ar period from January 2003 to December 2012. The results show that the hypothetical investment portfolio outperf orms both benchmarks, with superior performance espe-cially during the period following financial crisis. Overall, t his paper suggests that a mathematical approach for selecting and managing an optimal investment portfolio based on objective data can achieve outstanding performance in the foreign exchange market.