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The Implications of Mean-Variance Optimization for Four Questions in International Macroeconomics

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  • Jeffrey A. Frankel

Abstract

The hypothesis that investors optimize with respect to the mean and variance of their end-of-period wealth has powerful implications for some standard questions of interest to international macroeconomists. The implications transcend the particular econometric technique used to estimate the return variance-covarjance matrix. (1) For conventional estimates of risk-aversion, substitutability between domestic and foreign securities is close to perfect in the sense that risk premiums are small in magnitude (a few basis points), and thus cannot explain much bias in forward rates. (2) Nevertheless, as long as risk-aversion is not zero, foreign exchange intervention still affects the level of the exchange rate. If interest rates are held constant, the effect is proportionate to the contemporaneous change in asset supplies, and is more-than-proportionate if the expectations of future asset supplies also change. (3) Current account deficits have effects that are comparable to, though smaller in magnitude than,the effects of equal-sized changes in asset supplies through intervention or government borrowing. (4) The perceived tendency for dollar depreciation to be associated with appreciation of the mark against the franc is not consistent with the implication of mean-variance optimization that the franc should bea closer substitute for the dollar than is the mark.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1617.

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Date of creation: Jul 1986
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Handle: RePEc:nbr:nberwo:1617

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  1. Hodrick, Robert J., 1989. "Risk, uncertainty, and exchange rates," Journal of Monetary Economics, Elsevier, vol. 23(3), pages 433-459, May.
  2. Charles Engel & Anthony P. Rodrigues, 1987. "Tests of International CAPM with Time-Varying Covariances," NBER Working Papers 2303, National Bureau of Economic Research, Inc.
  3. Sarantis Kalyvitis & Ifigeneia Skotida, 2008. "Some Empirical Evidence on the Effects of U.S. Monetary Policy Shocks on Cross Exchange Rates," Working Papers 65, Bank of Greece.
  4. McCauley, R.N., 1997. "The Euro and the Dollar," Princeton Essays in International Economics 205, International Economics Section, Departement of Economics Princeton University,.
  5. Fischer Black, 1989. "Equilibrium Exchange Rate Hedging," NBER Working Papers 2947, National Bureau of Economic Research, Inc.
  6. Robert McCauley, 1999. "The Euro and the Dollar, 1998," Open Economies Review, Springer, vol. 10(1), pages 91-133, February.
  7. Zenón Jiménez-Ridruejo Ayuso & Mª Carmen Lorenzo Lago, 1996. "Análisis de variabilidad de la prima de riesgo," Estudios de Economía Aplicada, Estudios de Economía Aplicada, vol. 5, pages 33-57, Junio.
  8. Svensson, L.E.O., 1989. "Target Zones And Interest Rate Variability," Papers 457, Stockholm - International Economic Studies.
  9. Eichengreen, Barry, 2001. "The EMS Crisis in Retrospect," CEPR Discussion Papers 2704, C.E.P.R. Discussion Papers.
  10. W A Razzak, 1998. "The forward rate unbiasedness hypothesis in inflation-targeting regimes," Reserve Bank of New Zealand Discussion Paper Series G99/3, Reserve Bank of New Zealand, revised Aug 1999.
  11. Stefan C. Norrbin & F. Pinar Yigit, 2005. "The Robustness of the Link between Volatility and Growth of Output," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 141(2), pages 343-356, July.

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