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Ambiguity and the Home Currency Bias

Author

Listed:
  • Urban Ulrych

    (University of Zurich - Department of Banking and Finance; Swiss Finance Institute)

  • Nikola Vasiljevic

    (University of Zurich, Department of Banking and Finance)

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.

Suggested Citation

  • Urban Ulrych & Nikola Vasiljevic, 2020. "Ambiguity and the Home Currency Bias," Swiss Finance Institute Research Paper Series 20-73, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp2073
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    More about this item

    Keywords

    Ambiguity aversion; model uncertainty; optimal currency overlay; generalized ridge regression; international asset allocation;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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