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

Jeffrey Frankel and Charles Engel

No 1051, NBER Working Papers from National Bureau of Economic Research, Inc

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.

Date: 1982-12
Note: ITI IFM
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Published as Frankel, Jeffrey A. and Charles Engel. "Do Asset-Demand Functions Optimizeover the Mean and Variance of Real Returns? A Six-Currency Test." Journal of International Economics, Vol. 17, (December 1984), pp. 309-323.

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