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Optimal Currency Diversification for a Class of Risk Averse International Investors

  • Jorge Braga de Macedo

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.

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File URL: http://www.nber.org/papers/w0959.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0959.

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Date of creation: Aug 1982
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Publication status: published as de Macedo, Jorge Braga. "Optimal Currency Diversification for a Class ofRisk Averse International Investors." Journal of Economic Dynamics and Control ,Vol. 5, No. 2. (February 1983) pp. 173-185.
Handle: RePEc:nbr:nberwo:0959
Note: ITI IFM
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  1. 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.
  2. Rudiger Dornbusch, 1980. "Exchange Rate Risk and the Macroeconomics of Exchange Rate Determination," NBER Working Papers 0493, National Bureau of Economic Research, Inc.
  3. André Farber & Eugene Fama, 1979. "Money, bonds and foreign exchange," ULB Institutional Repository 2013/11356, ULB -- Universite Libre de Bruxelles.
  4. 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.
  5. Hodrick, Robert J., 1981. "International asset pricing with time-varying risk premia," Journal of International Economics, Elsevier, vol. 11(4), pages 573-587, November.
  6. Stulz, Rene M., 1983. "The demand for foreign bonds," Journal of International Economics, Elsevier, vol. 15(3-4), pages 225-238, November.
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