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Optimal close-to-home biases in asset allocation

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  • Varas, Felipe
  • Walker, Eduardo

Abstract

This article studies optimal portfolio decisions with (long-term) liabilities for small open economy based investors, including the optimality of currency hedging (Walker (2008a). Chile is the home country of the representative investor, but results are likely to hold more generally. The problem is set up as in (Sharpe & Tint, 1990) and (Hoevenaars et al., 2007). Hedging the liabilities and the consumption currency may imply optimal close-to-home biases, defined as overweighting asset classes which are highly correlated with local ones. The implementation challenges include: developing a methodology to estimate expected returns in local (real) currency; estimating the covariance matrix allowing for serial and crossed-serial correlations; and checking the results' robustness using a resampling method. The findings are: (i) portfolios always have optimal close-to-home biases, beyond the investment in local fixed income to hedge liabilities; (ii) currency hedging reduces investment in close-to-home asset classes, (iii) but has ambiguous effects on welfare -- detected with the resampling method; (iv) currency hedged long-term US bonds are useful for hedging local interest rate risk; and (v) liabilities give access to high risk-return portfolios, not affecting otherwise the overall shape of the efficient regions. This article can be useful to investors based on small open economies, including pension funds, insurance companies, sovereign wealth funds and Central Banks.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Business Research.

Volume (Year): 64 (2011)
Issue (Month): 3 (March)
Pages: 328-337

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Handle: RePEc:eee:jbrese:v:64:y:2011:i:3:p:328-337

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Web page: http://www.elsevier.com/locate/jbusres

Related research

Keywords: Asset allocation Hedging Liabilities Resampling Home bias Interest rate risk Currency risk Small open economies Emerging markets Chile;

References

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  1. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
  2. John Y. Campbell & Luis M. Viceira, 2000. "Who Should Buy Long-Term Bonds?," Harvard Institute of Economic Research Working Papers 1895, Harvard - Institute of Economic Research.
  3. Walker, Eduardo, 2008. "Strategic currency hedging and global portfolio investments upside down," Journal of Business Research, Elsevier, vol. 61(6), pages 657-668, June.
  4. Bekaert, Geert & Harvey, Campbell R., 1997. "Emerging equity market volatility," Journal of Financial Economics, Elsevier, vol. 43(1), pages 29-77, January.
  5. Hoevenaars, Roy P.M.M. & Molenaar, Roderick D.J. & Schotman, Peter C. & Steenkamp, Tom B.M., 2008. "Strategic asset allocation with liabilities: Beyond stocks and bonds," Journal of Economic Dynamics and Control, Elsevier, vol. 32(9), pages 2939-2970, September.
  6. Campbell R. Harvey, 1994. "Predictable Risk and Returns in Emerging Markets," NBER Working Papers 4621, National Bureau of Economic Research, Inc.
  7. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 627-627, November.
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Cited by:
  1. Eduardo Walker, 2008. "Assessing Alternative Institutional Designs For Investment Regulation In Defined Contribution Pension Funds," Abante, Escuela de Administracion. Pontificia Universidad Católica de Chile., vol. 11(2), pages 121-152.
  2. Brenes, Esteban R. & Metzger, Michael & Requena, Bernardo, 2011. "Strategic management in Latin America: Issues and assessment," Journal of Business Research, Elsevier, vol. 64(3), pages 231-235, March.

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