Hedging demand in long-term currency carry trade asset allocation problems.

R. Laborda and J. Olmo. (2022). Hedging demand in long-term currency carry trade asset allocation problems. Journal of Financial Econometrics 20 3, 472-504.

In this paper we derive sucient conditions for the existence of a positive hedging demand under the presence of predictability of the carry trade return using single and multiple state variables. The main driver of the hedging demand is the presence of positive correlation between the state variables and the next period return on the carry trade strategy. We also find conditions under which the hedging demand is increasing with the investment horizon. These theoretical insights are empirically assessed in an optimal asset allocation exercise for different levels of investor's risk aversion and investment horizons. Suitable state variables driving the allocation to the currency carry trade strategy are those that predict the risk premium on the carry trade strategy, namely, the currency volatility momentum, the level and three-month change of the U.S. Ted spread and the three-month change of the CRB commodity index. The magnitude of the hedging demand decreases linearly as the relative risk aversion coefficient increases, however, the relationship between the hedging demand and the investment horizon is highly nonlinear and varies significantly depending on whether there is a single state variable for predicting the carry trade return
or more than one. These results are robust across different choices of carry trade strategies and risk aversion coefficients.

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