Ambiguity and the Home Currency Bias

46 Pages Posted: 31 Aug 2020

See all articles by Urban Ulrych

Urban Ulrych

University of Zurich - Department of Banking and Finance; Swiss Finance Institute

Nikola Vasiljevic

University of Zurich, Department of Banking and Finance

Date Written: August 28, 2020

Abstract

This paper addresses the question of optimal currency exposure for a risk-and-ambiguity-avers international investor. A robust mean-variance model with smooth ambiguity preferences is used to derive the optimal currency exposure. In the theoretical part, we show that the sample-efficient currency demand can be calculated as the solution to a generalized ridge regression. Through the lens of these results, we demonstrate that our ambiguity-based model offers a new explanation of the home currency bias. The investor's dislike for model uncertainty induces a disproportionately high currency hedging demand. The empirical analysis of currency overlay strategies employs the foreign exchange, equity, and bond returns over the period from 1999 to 2018. Our out-of-sample back-tests illustrate that accounting for ambiguity enhances the stability of estimated optimal currency exposures and significantly improves the portfolio performance net of transaction costs.

Keywords: Ambiguity aversion, model uncertainty, optimal currency overlay, generalized ridge regression, international asset allocation

JEL Classification: D81, D83, F31, G11, G15

Suggested Citation

Ulrych, Urban and Vasiljevic, Nikola, Ambiguity and the Home Currency Bias (August 28, 2020). Swiss Finance Institute Research Paper No. 20-73, Available at SSRN: https://ssrn.com/abstract=3683821 or http://dx.doi.org/10.2139/ssrn.3683821

Urban Ulrych (Contact Author)

University of Zurich - Department of Banking and Finance ( email )

Plattenstr 32
Zurich, 8032
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Nikola Vasiljevic

University of Zurich, Department of Banking and Finance ( email )

Plattenstrasse 14
Zurich, CH-8032
Switzerland

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