Ambiguity's Role in Global Currency Hedging and Portfolio Stability

© 2025 EPFL

© 2025 EPFL

The paper written by Dr. Urban Ulrych and co-author Nikola Vasiljević has been published in the Journal of Banking & Finance. It explores optimal currency allocation for international investors who are both risk- and ambiguity-averse, using a robust mean–variance model that incorporates smooth ambiguity preferences. The findings show that accounting for ambiguity increases hedging demand, reduces estimation bias, and improves portfolio stability, as demonstrated through empirical analysis and out-of-sample backtesting.

Global currency hedging with ambiguity

Abstract

This paper examines the issue of optimal currency allocation for an international investor who is both risk- and ambiguity-averse. 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.