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Optimal close-to-home biases in asset allocation

  • Varas, Felipe
  • Walker, Eduardo

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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File URL: http://www.sciencedirect.com/science/article/B6V7S-4Y648FF-1/2/c7c582018ffcddf4f8db87a26ecaef65
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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
Contact details of provider: Web page: http://www.elsevier.com/locate/jbusres

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  1. Bekaert, Geert & Harvey, Campbell R., 1997. "Emerging equity market volatility," Journal of Financial Economics, Elsevier, vol. 43(1), pages 29-77, January.
  2. Campbell R. Harvey, 1994. "Predictable Risk and Returns in Emerging Markets," NBER Working Papers 4621, National Bureau of Economic Research, Inc.
  3. 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.
  4. Walker, Eduardo, 2009. "Los mercados de las rentas vitalicias en Chile. Competencia, regulación, ¿y miopía?," El Trimestre Económico, Fondo de Cultura Económica, vol. 0(301), pages 145-179, enero-mar.
  5. John Y. CAMPBELL & Luis VICEIRA, 1998. "Who Should Buy Long-Term Bonds?," FAME Research Paper Series rp5, International Center for Financial Asset Management and Engineering.
  6. Walker, Eduardo, 2008. "Strategic currency hedging and global portfolio investments upside down," Journal of Business Research, Elsevier, vol. 61(6), pages 657-668, June.
  7. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
  8. 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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