Academic journal article Economic Inquiry

Exchange Rate Systems and Investor Preferences

Academic journal article Economic Inquiry

Exchange Rate Systems and Investor Preferences

Article excerpt


Dissatisfaction with the performance in the 1980s of floating exchange rates has lead to renewed interest in a system of target zones for foreign exchange rates or a partial return to fixed exchange rates. Consideration of these proposals raises many of the same questions about the economic effects of fixed vs. flexible exchange rates that were addressed in the late 1960s and early 1970s. Although there are several issues of interest, both at the macroeconomic level and at the level of the individual investor, in this paper, we focus on only one: Do floating exchange rates increase the riskiness of international investment positions so that investors would prefer the distribution of returns existing under a fixed exchange rate regime?

This question--whether international financial transactions are more risky under floating than under fixed rates--was a major point of controversy in the debate over the adoption of floating exchange rates. (For a review of the arguments see, for example, Friedman [1953] or Halm [1970].) Once again, this issue has arisen. McKinnon [1988, 86] argues:

I hypothesize that a floating exchange

market is socially inefficient because

private foreign exchange traders face

a huge gap in relevant information;

the relative future purchasing powers

of national fiat monies, none of which

has any intrinsic value, are highly uncertain.

Thus, the assessments of

international investors of whether

dollar, or yen, or mark assets provide

the best combination of yield and

safety are unnecessarily volatile.

We might suppose, then, that this excess volatility will reduce international investment activity relative to what a fixed rate regime would encourage.

McKinnon is by no means alone in the belief that floating exchange rates add an undesirable level of risk to international investment positions (see Edison and Melvin [1990] for a review of this literature); however, there has been little empirical work done on whether the move to floating rates did, in fact, add an undesirable level of risk. Our study is intended to shed light on this issue. Specifically, we ask: Which group of risk averse investors prefers the distribution of returns under a fixed exchange rate regime and which prefers the distribution of returns under a floating exchange rate regime?

We begin by using a stochastic dominance approach to investigate exchange rate risk for twelve countries from the viewpoint of an investor holding currencies. Both U.S. and non-U.S. investors are considered, and we explore the risk-taking characteristics of those investors who would prefer one regime to another. We find that the fixed rate regime should be overwhelmingly preferred by all risk averse investors holding currencies.

Next, we consider the uncovered returns on foreign stocks. Again, we consider both the U.S. and non-U.S. investor. We find that the floating rate regime should be preferred by all risk averse investors. This finding for uncovered stock portfolios indicates that floating rates have not created a level of risk that investors consider excessive.

Before proceeding, we should address the problem of comparing two alternative exchange rate systems over two different time periods. The greater variability of flexible exchange rates in the 1970s and 1980s, compared to the earlier pegged rates is not entirely attributable to the change in the nominal exchange rate regime. The 1970s and 1980s were characterized by more frequent and more serious real shocks to the global economy than was true of the 1950s and 1960s. Because of this difference, we cannot assert, based on a retrospective view of real returns to investors under alternative exchange rate systems, that investors would generally prefer one exchange rate regime to another. …

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