Hedging Currency Risk: a Regret-Theoretic Approach

Contrary to the predictions of existing normative currency-hedging models, a wide diversity of hedging policies is observed among institutional investors. We propose an alternative model of optimal currency-hedging choices based on regret theory, a normative and axiomatic behavioral theory. With hindsight, investors may experience regret of not having taken the ex post optimal hedging decision; i.e. full hedging if the foreign currency depreciated, or no hedging if the foreign currency appreciated. Hence, investors include expected future regret in their objective function. As a result, our model features two components of risk: traditional risk and regret. We derive closed-form optimal hedging rules using the Arrow-Pratt approach and highlight the difference with the traditional expected-utility results. We find that differences in the level of regret aversion among investors may explain why we observe such a wide diversity of currency hedging policies among institutional investors.