Hedging Demand in Long-Term Asset Allocation With an Application to Carry Trade Strategies

57 Pages Posted: 14 Jun 2019 Last revised: 11 Jun 2020

See all articles by Ricardo Laborda Herrero

Ricardo Laborda Herrero

Centro Universitario de la Defensa de Zaragoza

Jose Olmo

Universidad de Zaragoza; University of Southampton

Date Written: June 10, 2020

Abstract

We derive a closed-form expression for the mean and marginal hedging demand on risky assets in long-term asset allocation problems for individuals with CRRA preferences. Our parametric portfolio policy rule accommodates an arbitrarily large number of state variables for predicting the state of nature, and number of assets in the portfolio. The closed-form expression for the hedging demand is exact under polynomial specifications of the portfolio policy rule and a suitable approximation for unknown smooth parametric portfolio policy rules using Taylor expansions. The hedging demand on risky assets depends positively on the predictability of the risky asset and the persistence of the predictors, and negatively on the degree of investor's relative risk aversion. We illustrate these insights empirically for a basket of currencies by showing the outperformance of rebalancing carry trade strategies over different investment horizons against a short-term (myopic) portfolio.

Keywords: currency carry trade, hedging demand, parametric portfolio policy rules, strategic asset allocation, state variables

JEL Classification: G11, G15, F31

Suggested Citation

Laborda Herrero, Ricardo and Olmo, Jose, Hedging Demand in Long-Term Asset Allocation With an Application to Carry Trade Strategies (June 10, 2020). Available at SSRN: https://ssrn.com/abstract=3398982 or http://dx.doi.org/10.2139/ssrn.3398982

Ricardo Laborda Herrero

Centro Universitario de la Defensa de Zaragoza ( email )

Academia General Militar, Ctra. de Huesca, s/n
Zaragoza, Zaragoza 50009
Spain

Jose Olmo (Contact Author)

Universidad de Zaragoza ( email )

Gran Via, 2
50005 Zaragoza, Zaragoza 50005
Spain

University of Southampton ( email )

Southampton
United Kingdom

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