Applying Regret Theory to Investment Choices: Currency Hedging Decisions

43 Pages Posted: 7 Jul 2005

See all articles by Sebastien Michenaud

Sebastien Michenaud

Kellstadt Graduate School of Business

Bruno Solnik

Hong Kong University of Science & Technology (HKUST) - Department of Finance ; HEC Paris - Departement Finance et Economie

Date Written: January 2008

Abstract

We apply regret theory, an axiomatic behavioral theory, to derive closed-form solutions to optimal currency hedging choices. Investors experience regret of not having chosen the ex-post optimal hedging decision. Hence, investors anticipate their future experience of regret and incorporate it in their objective function. We derive a model of financial decision-making with two components of risk: traditional risk (volatility) and regret risk. We find results that are in sharp contrast with traditional expected utility, loss aversion, or disappointment aversion theories. We discuss the empirical implications of our model and its ability to explain observed hedging behavior.

Keywords: Behavioral finance, hedging

JEL Classification: G11, G15

Suggested Citation

Michenaud, Sebastien and Solnik, Bruno, Applying Regret Theory to Investment Choices: Currency Hedging Decisions (January 2008). Available at SSRN: https://ssrn.com/abstract=676728 or http://dx.doi.org/10.2139/ssrn.676728

Sebastien Michenaud

Kellstadt Graduate School of Business ( email )

1 East Jackson Blvd.
Chicago, IL 60604
United States
(312)362-5001 (Phone)

HOME PAGE: http://www.sebastienmichenaud.com

Bruno Solnik (Contact Author)

Hong Kong University of Science & Technology (HKUST) - Department of Finance ( email )

Clear Water Bay, Kowloon
Hong Kong

HEC Paris - Departement Finance et Economie ( email )

1, rue de la Liberation
Jouy-en-Josas Cedex, 78351
France
+33 1 39 67 72 84 (Phone)
+33 1 39 67 70 85 (Fax)

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