Working Paper

New Evidence on the Portfolio Balance Approach to Currency Returns

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Asset markets are indispensable in harnessing society’s diverse views and insights about future business performance. But those views are shaped as much by emotion and crowd mentality as by rational expectations.

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.