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Do Asset-Demand Functions Optimize over the Mean and Variance of Real Returns? A Six-Currency Test

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  • Jeffrey A. Frankel
  • Charles Engel

Abstract

International asset demands are functions of expected returns.Optimal portfolio theory tells us that the coefficients in this relationship depend on the variance-covariance matrix of real returns.But previous estimates of the optimal portfolio (1) assume expected returns constant and (2) are not set up to test the hypothesis of mean-variance optimization. We use maximum likelihood estimation to impose a constraint between the coefficients and the error variance-covariance matrix. For a portfolio of six currencies, we are able statistically to reject the constraint. Evidently investors are either not sophisticated enough to maximize a function of the mean and variance of end-of-period wealth, or else are too sophisticated to do so.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1051.

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Date of creation: Dec 1982
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Publication status: published as Frankel, Jeffrey A. and Charles Engel. "Do Asset-Demand Functions Optimizeover the Mean and Variance of Real Returns? A Six-Currency Test." Journal of International Economics, Vol. 17, (December 1984), pp. 309-323.
Handle: RePEc:nbr:nberwo:1051

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  1. Stulz, ReneM., 1981. "A model of international asset pricing," Journal of Financial Economics, Elsevier, vol. 9(4), pages 383-406, December.
  2. Cornell, W Bradford & Dietrich, J Kimball, 1978. "The Efficiency of the Market for Foreign Exchange under Floating Exchange Rates," The Review of Economics and Statistics, MIT Press, vol. 60(1), pages 111-20, February.
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  4. Mussa, Michael, 1979. "Empirical regularities in the behavior of exchange rates and theories of the foreign exchange market," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 11(1), pages 9-57, January.
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  14. Grauer, Frederick L. A. & Litzenberger, Robert H. & Stehle, Richard E., 1976. "Sharing rules and equilibrium in an international capital market under uncertainty," Journal of Financial Economics, Elsevier, vol. 3(3), pages 233-256, June.
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