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The implications of mean-variance optimization for four questions in international macroeconomics

  • Frankel, Jeffrey A.

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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Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 5 (1986)
Issue (Month): 1, Supplement (March)
Pages: S53-S75

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Handle: RePEc:eee:jimfin:v:5:y:1986:i:1:p:s53-s75
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30443

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