Ambiguity and the Home Currency Bias
46 Pages Posted: 31 Aug 2020
Date Written: August 28, 2020
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
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