Estimation Risk and International Bond Portfolio Selection
Posted: 20 Dec 1998
In this paper, we study the performance of expected return estimators proposed to alleviate estimation risk on international bond data. More precisely, we test, besides the historical mean vector, the James-Stein estimator as well as the Bayes-Stein estimator. Although there is ample evidence for the presence of estimation risk, we find that the alternative estimators do not always outperform the historical mean vector. These results, which are not in accordance with other papers, are largely due to the imposition of the no-short sales restriction. Secondly, we also focus on the influence exchange rate fluctuations have on estimation risk. We find that exchange rate fluctuations imply higher correlations between returns, and thus higher estimation risk. Finally, we test whether hedging exchange rate risk also eliminates estimation risk. For some investors and time periods hedging is useful and eliminates both exchange rate risk and part of the estimation risk.
JEL Classification: F31, G12
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