Do Asset-Demand Functions Optimize Over the Mean and Variance of Real Returns? A Six-Currency Test

28 Pages Posted: 11 Apr 2004 Last revised: 17 Nov 2022

See all articles by Jeffrey A. Frankel

Jeffrey A. Frankel

Harvard University - Harvard Kennedy School (HKS); National Bureau of Economic Research (NBER)

Charles M. Engel

University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER); University of Washington - Department of Economics

Date Written: December 1982

Abstract

International asset demands are functions of expected returns.Optimal portfolio theory tells us that the coefficients in this relationship depend on the variance-covariance matrix of real returns.But previous estimates of the optimal portfolio (1) assume expected returns constant and (2) are not set up to test the hypothesis of mean-variance optimization. We use maximum likelihood estimation to impose a constraint between the coefficients and the error variance-covariance matrix. For a portfolio of six currencies, we are able statistically to reject the constraint. Evidently investors are either not sophisticated enough to maximize a function of the mean and variance of end-of-period wealth, or else are too sophisticated to do so.

Suggested Citation

Frankel, Jeffrey A. and Engel, Charles M., Do Asset-Demand Functions Optimize Over the Mean and Variance of Real Returns? A Six-Currency Test (December 1982). NBER Working Paper No. w1051, Available at SSRN: https://ssrn.com/abstract=304783

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