Working Paper: NBER ID: w1051
Authors: Jeffrey A. Frankel; Charles Engel
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.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Investors do not optimize their asset demands according to the mean and variance of real returns (G11) | Likelihood ratio test rejects the constraint of mean-variance optimization (C52) |
| Rejection of the hypothesis of mean-variance optimization (G40) | Investors lack the sophistication to maximize their end-of-period wealth (G11) |
| Rejection of the hypothesis of mean-variance optimization (G40) | Investors may be employing a more complex intertemporal utility function (D15) |
| Expected returns and variance-covariance matrix of returns (G17) | Coefficients of the asset demand functions (G19) |
| Parameters of the asset demand functions depend on expected returns and risk aversion (D11) | Actual behavior of investors deviates from theoretical expectation (G41) |