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| Type | Working Paper |
| Scope | Discipline-based scholarship |
| Title | Ambiguity and the Home Currency Bias |
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| Institution | University of Zurich |
| Series Name | Swiss Finance Institute Research Paper |
| Number | 20-73 |
| Date | 2020 |
| Abstract Text | 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. |
| Official URL | https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3683821 |
| Other Identification Number | merlin-id:19817 |
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