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Do asset-demand functions optimize over the mean and variance of real returns? A six-currency test

1984; Elsevier BV; Volume: 17; Issue: 3-4 Linguagem: Inglês

10.1016/0022-1996(84)90026-6

1873-0353

Jeffrey A. Frankel, Charles Engel,

Complex Systems and Time Series Analysis

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.