Global currency hedging with ambiguity

Utilizing a robust mean–variance model that incorporates smooth ambiguity preferences, we derive a closed-form solution for the optimal currency exposure. Within this theoretical framework, the demand for optimal currency hedging is formulated as the solution to a generalized ridge regression. Our findings indicate that the investor's aversion to model uncertainty increases the demand for hedging. The empirical analysis illustrates that ambiguity introduces greater estimation bias and narrows the confidence interval of the optimal currency exposure estimator. An out-of-sample backtest further demonstrates that incorporating ambiguity into the model improves the stability of optimal currency allocation over time and significantly reduces portfolio volatility after accounting for transaction costs.

Authors

Publication Details

Journal
Journal of Banking & Finance
Published
2024-12-28
DOI
https://doi.org/10.1016/j.jbankfin.2024.107366
Citations
6
Primary Topic
Monetary Policy and Economic Impact
Type
article
Field-Weighted Citation Impact
4.97

Funders

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article

Global currency hedging with ambiguity

Urban Ulrych, Nikola Vasiljević
6 citations
Journal of Banking & Finance
Monetary Policy and Economic Impact
4.97
article

Global currency hedging with ambiguity

Urban Ulrych, Nikola Vasiljević
article en
6 citations

Abstract

Utilizing a robust mean–variance model that incorporates smooth ambiguity preferences, we derive a closed-form solution for the optimal currency exposure. Within this theoretical framework, the demand for optimal currency hedging is formulated as the solution to a generalized ridge regression. Our findings indicate that the investor's aversion to model uncertainty increases the demand for hedging. The empirical analysis illustrates that ambiguity introduces greater estimation bias and narrows the confidence interval of the optimal currency exposure estimator. An out-of-sample backtest further demonstrates that incorporating ambiguity into the model improves the stability of optimal currency allocation over time and significantly reduces portfolio volatility after accounting for transaction costs.

Journal of Banking & FinanceVol. 172
École Polytechnique Fédérale de Lausanne, Eidgenössische Technische Hochschule Zürich, Universität Zürich
Decent work and economic growth
Openalex Percentile: Top 4%
Monetary Policy and Economic Impact
4.97
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