Applying Regret Theory to Investment Choices: Currency Hedging Decisions

Abstract

We apply regret theory, an axiomatic behavioral theory, to derive closed-form solutions to optimal currency hedging choices. Investors experience regret of not having chosen the ex-post optimal hedging decision. Hence, investors anticipate their future experience of regret and incorporate it in their objective function. We derive a model of financial decision-making with two components of risk: traditional risk (volatility) and regret risk. We find results that are in sharp contrast with traditional expected utility, loss aversion, or disappointment aversion theories. We discuss the empirical implications of our model and its ability to explain observed hedging behavior.

Keywords: Behavioral finance, hedging

JEL Classification: G11, G15