Ambiguity and the Home Currency Bias

Urban Ulrych and Nikola Vasiljevic
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Urban Ulrych: University of Zurich - Department of Banking and Finance; Swiss Finance Institute
Nikola Vasiljevic: University of Zurich, Department of Banking and Finance

No 20-73, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

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 (search for similar items in EconPapers)
JEL-codes: D81 D83 F31 G11 G15 (search for similar items in EconPapers)
Pages: 46 pages
Date: 2020-08
New Economics Papers: this item is included in nep-rmg and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2073

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