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Optimal Currency Diversification for a Class of Risk Averse International Investors

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  • Jorge Braga de Macedo

Abstract

In the framework of continuous-time finance theory, this paper derives the optimal consumption and portfolio rules for an international investor with constant expenditure shares [alpha, sub j] and constant relative risk aversion [1-gamma] in a dynamic context. The index of value obtained from the consumption rule is used to obtain real returns on N different currencies in terms of their purchasing power over N goods. The portfolio rule is expressed in terms of the determinants of the purchasing powers, namely exchange rates and prices expressed in the numeraire currency. The optimal portfolio is interpreted as a capital position given by the expenditure shares and hedging zero net-worth portfolios depending on unanticipated inflation and risk aversion. It is shown that the minimum variance portfolio is independent of returns, but depends on expenditure patterns. While the speculative portfolio depends on risk aversion and real return differentials. When the effect of references on real return differentials is made explicit, it is shown that the minimum variance portfolio is affected by risk aversion. In that case, the effect of an increase in [alpha, sub i] on the portfolio proportions [x, sub i] will be positive when relative risk aversion is greater than one, as generally presumed. Actual data from eight major countries is used to compute optimal portfolios based on real return differentials for different weighting schemes, degrees of risk aversion and sample periods when exchange rates and prices are assumed to be Brownian.

Suggested Citation

  • Jorge Braga de Macedo, 1982. "Optimal Currency Diversification for a Class of Risk Averse International Investors," NBER Working Papers 0959, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:0959
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    References listed on IDEAS

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    1. Fama, Eugene F & Farber, Andre, 1979. "Money, Bonds, and Foreign Exchange," American Economic Review, American Economic Association, vol. 69(4), pages 639-649, September.
    2. Merton, Robert C., 1975. "Theory of Finance from the Perspective of Continuous Time," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 10(04), pages 659-674, November.
    3. Hodrick, Robert J., 1981. "International asset pricing with time-varying risk premia," Journal of International Economics, Elsevier, vol. 11(4), pages 573-587, November.
    4. Stulz, Rene M., 1983. "The demand for foreign bonds," Journal of International Economics, Elsevier, vol. 15(3-4), pages 225-238, November.
    5. Rudiger Dornbusch, 1980. "Exchange Rate Economics: Where Do We Stand?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 11(1, Tenth ), pages 143-206.
    6. Rudiger Dornbusch, 1980. "Exchange Rate Risk and the Macroeconomics of Exchange Rate Determination," NBER Working Papers 0493, National Bureau of Economic Research, Inc.
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    Cited by:

    1. Nicolas Coeurdacier & Hélène Rey, 2013. "Home Bias in Open Economy Financial Macroeconomics," Journal of Economic Literature, American Economic Association, vol. 51(1), pages 63-115, March.
    2. Tille, Cédric & van Wincoop, Eric, 2010. "International capital flows," Journal of International Economics, Elsevier, vol. 80(2), pages 157-175, March.
    3. Puri, Tribhuvan N., 1996. "Capital flows and net international investment," International Review of Financial Analysis, Elsevier, vol. 5(2), pages 113-130.
    4. Eric van Wincoop & Francis E. Warnock, 2006. "Is Home Bias in Assets Related to Home Bias in Goods?," NBER Working Papers 12728, National Bureau of Economic Research, Inc.
    5. van Wincoop, Eric & Warnock, Francis E., 2010. "Can trade costs in goods explain home bias in assets?," Journal of International Money and Finance, Elsevier, vol. 29(6), pages 1108-1123, October.
    6. Mohammad R. Safarzadeh & Fatemeh Ibrahimi Nazarian & Ana Kristel C. Molina, 2013. "Efficiency of Currency Asset Classes," International Journal of Economics and Financial Issues, Econjournals, vol. 3(2), pages 544-558.

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