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New Evidence on the Portfolio Balance Approach to Currency Returns

Author

Listed:
  • Nevin Cavusoglu

    (James Madison University)

  • Michael D. Goldberg

    (University of New Hampshire)

  • Joshua Stillwagon

    (Babson College)

Abstract

This paper re-examines the empirical performance of the portfolio balance approach to currency returns. It considers the implications of two alternative specifications of preferences: one based on expected utility theory and the other on prospect theory. It also uses survey data to estimate models of ex-ante rather than ex-post returns. The empirical analysis relies on the co-integrated VAR framework, which is well suited for testing competing models and dealing with unit roots. Like earlier studies, we find little support for the expected utility theory model. By contrast, the prospect theory model`s predictions are largely borne out in the data, including those about sign reversals. We find the strongest support for a hybrid model that incorporates the risk factors of both portfolio balance specifications.

Suggested Citation

  • Nevin Cavusoglu & Michael D. Goldberg & Joshua Stillwagon, 2019. "New Evidence on the Portfolio Balance Approach to Currency Returns," Working Papers Series 89, Institute for New Economic Thinking.
  • Handle: RePEc:thk:wpaper:89
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    International CAPM; Prospect Theory; Risk Premium; Co-integrated VAR; Survey Expectations;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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