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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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  1. Cumby, Robert E & Obstfeld, Maurice, 1981. "A Note on Exchange-Rate Expectations and Nominal Interest Differentials: A Test of the Fisher Hypothesis," Journal of Finance, American Finance Association, vol. 36(3), pages 697-703, June.
  2. Cornell, Bradford, 1977. "Spot rates, forward rates and exchange market efficiency," Journal of Financial Economics, Elsevier, vol. 5(1), pages 55-65, August.
  3. Park, Keehwan, 1984. "Tests of the hypothesis of the existence of risk premium in the foreign exchange market," Journal of International Money and Finance, Elsevier, vol. 3(2), pages 169-178, August.
  4. Jeffrey A. Frankel & Charles Engel, 1982. "Do Asset-Demand Functions Optimize over the Mean and Variance of Real Returns? A Six-Currency Test," NBER Working Papers 1051, National Bureau of Economic Research, Inc.
  5. Loopesko, Bonnie E., 1984. "Relationships among exchange rates, intervention, and interest rates: An empirical investigation," Journal of International Money and Finance, Elsevier, vol. 3(3), pages 257-277, December.
  6. Rogoff, Kenneth, 1984. "On the effects of sterilized intervention : An analysis of weekly data," Journal of Monetary Economics, Elsevier, vol. 14(2), pages 133-150, September.
  7. Frankel, Jeffrey A., 1979. "The diversifiability of exchange risk," Journal of International Economics, Elsevier, vol. 9(3), pages 379-393, August.
  8. Paul R. Krugman, 1981. "Consumption Preferences, Asset Demands, and Distribution Effects in International Financial Markets," NBER Working Papers 0651, National Bureau of Economic Research, Inc.
  9. Gregory, Allan W. & McCurdy, Thomas H., 1984. "Testing the unbiasedness hypothesis in the forward foreign exchange market: A specification analysis," Journal of International Money and Finance, Elsevier, vol. 3(3), pages 357-368, December.
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