Hedging Demand in Long-Term Asset Allocation with an Application to Carry Trade Strategies*

Variable Selection for Portfolio Choice

Ricardo Laborda and Jose Olmo

Journal of Financial Econometrics, 2022, vol. 20, issue 3, 472-504

Abstract: We derive a closed-form expression for the mean and marginal hedging demand on risky assets in long-term asset allocation problems for individuals with constant relative risk aversion preferences. Our parametric portfolio policy rule accommodates an arbitrarily large number of state variables for predicting the state of nature and number of assets in the portfolio. The closed-form expression for the hedging demand is exact under polynomial specifications of the portfolio policy rule and a suitable approximation for unknown smooth parametric portfolio policy rules using Taylor expansions. The hedging demand on risky assets depends positively on the predictability of the risky asset and the persistence of the predictors, and negatively on the degree of investor’s relative risk aversion. We illustrate these insights empirically for a basket of currencies by showing the outperformance of rebalancing carry trade strategies over different investment horizons against a short-term (myopic) portfolio.

Keywords: currency carry trade; hedging demand; parametric portfolio policy rules; state variables; strategic asset allocation (search for similar items in EconPapers)
JEL-codes: F31 G11 G15 (search for similar items in EconPapers)
Date: 2022
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