Global Currency Hedging with Ambiguity

Abstract

This paper addresses the problem of optimal currency allocation for a risk-and-ambiguity-averse international investor. A robust mean-variance model with smooth ambiguity preferences is used to derive the optimal currency exposure in closed form. In the theoretical part of the paper, we characterize the sample-efficient currency hedging demand as the solution to a generalized ridge regression. Through the lens of these results, we show that the investor's dislike for model uncertainty induces stronger currency hedging demand. The empirical analysis demonstrates how ambiguity leads to a larger estimation bias and simultaneously narrows the confidence interval of the sample efficient optimal currency exposure. The out-of-sample backtest illustrates that accounting for ambiguity enhances the stability of optimal currency allocation over time and significantly reduces portfolio volatility net of transaction costs.

Keywords: Ambiguity Aversion, Currency Hedging, Ridge Regression, International Asset Allocation.

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