Ambiguity and the Home Currency Bias

Abstract

This paper addresses the question of optimal currency exposure 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 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.

Dynamic currency hedging with non-Gaussianity and ambiguity

“…In this section, the theoretical model is presented. First, following Ulrych and Vasiljević (2020), a general framework for portfolio optimization in an international context is introduced. Next, we briefly recap the common market factor non-Gaussian returns (COMFORT) model, introduced by Paolella and Polak (2015a), which is used for modeling the asset and currency returns.…”

“…on currency c at time t + 1 denominated in domestic currency. Note that the investment universe could be extended by assuming that the total number of foreign currencies available on the market is greater than K, see Ulrych and Vasiljević (2020).…”

“…( 10) is the optimal currency exposure for a risk-and-ambiguity-averse international investor. It is derived in Ulrych and Vasiljević (2020) and is, in closed form, given by…”

“…( 10) and (11) determine the objective function and arbitrary linear constraints on optimal exposures can be prescribed. The solution is then obtained numerically; for more details, see Ulrych and Vasiljević (2020).…”

“…Boudoukh et al (2019) provided a decomposition of a currency overlay portfolio in a mean-variance framework consisting of a hedge sub-portfolio and an alpha-seeking currency sub-portfolio. Ulrych and Vasiljević (2020) generalized this concept to the risk and ambiguity aversion and showed that investors' dislike for model uncertainty induces stronger currency hedging demand.…”