EXCHANGE RATE SYSTEMS AND INVESTOR PREFERENCES MICHAEL MELVIN and MICHAEL B. ORMISTON*

This paper investigates whether or not floating exchange rates add an undesirable level of risk to international investment positions. For investors holding currencies, we find that fixed exchange rates are preferred to floating exchange rates, which sup- ports the often-argued case that floating exchange rates do excessively increase the riskiness of investnzent. However, in the more realistic case of investors holding foreign securities, we find that floating exchange rates are preferred to jixed exchange rates; that is, we find that floating exchange rates have not added an undesirable level of risk to international investment positions.

I. INTRODUCTION

Dissatisfaction with the performance in the 1980s of floating exchange rates has lead to renewed interest in a system of tar- get 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 eco- nomic effects of fixed vs. flexible exchange rates that were addressed in the late 1960s and early 1970s. Although there are sev- eral issues of interest, both at the macro- economic level and at the level of the in- dividual investor, in this paper, we focus on only one: Do floating exchange rates increase the riskiness of international in- vestment positions so that investors would prefer the distribution of returns existing under a fixed exchange rate re- gime?

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 ex- change rates. (For a review of the argu- ments see, for example, Friedman [1953]

Department of Economics, Arizona State Univer- sity. We are grateful to Richard Sweeney and two anonymous referees for their comments and sugges- tions. Ali Kutan provided helpful research assistance.

or Halm [1970].) Once again, this issue has arisen. McKinnon [1988, 861 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 un- certain. 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 ex- cess volatility will reduce international in- vestment 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 Mel- vin [1990] for a review of this literature); however, there has been little empirical work done on whether the move to float- ing 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 pre- fers the distribution of returns under a fixed exchange rate regime and which pre- fers the distribution of returns under a floating exchange rate regime?

We begin by using a stochastic domi- nance approach to investigate exchange

Economic Inquiry Vol. XXIX, July 1991,446-457

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@Western Economic Association International

MELVIN & ORMISTON EXCHANGE RATE SYSTEMS 447

rate risk for twelve countries from the viewpoint of an investor holding curren- cies. 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 re- turns on foreign stocks. Again, we con- sider both the US. and non-U.S. investor. We find that the floating rate regime should be preferred by all risk averse in- vestors. This finding for uncovered stock portfolios indicates that floating rates have not created a level of risk that invest- ors 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 re- gime. The 1970s and 1980s were character- ized 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 an- other. At most, we can make inferences re- garding which of the past periods invest- ors should have preferred. Would they have preferred the distribution of returns that was available until 1971, or the distri- bution that was available during the late 1970s and 1980s? This is still a relevant test, as the case for more stable exchange rates is often made by referring to these two periods.

Recognizing that real shocks to the economy will affect the real returns to in- vestors independent of the nominal ex- change rate system, there is still persua-

sive evidence that the nominal exchange rate system itself has a significant effect on real exchange rate variability. Stockman [1983] examined thirty-eight countries, in- cluding some that had floating exchange rates prior to 1973 or pegged exchange rates after 1973, to try to separate the ef- fects of the nominal exchange rate system from the effects of greater variability of ex- ogenous shocks. He found that countries pegging their nominal exchange rates to the U.S. dollar after 1973, on average ex- perienced an increase in real exchange rate variability that was less than half of that experienced by countries with floating currencies.

Mussa [1986] offers evidence support- ing Stockman's. After examining real ex- change rate performance over many coun- tries and time periods, Mussa concludes:

It should be emphasized that this study does indicate that the choice of a nominal exchange rate regime has important economic consequences. Real exchange rates do exhibit sub- stantially and systematically different behavior under different nominal ex- change rate regimes. [p. 2021

These studies simply confirm what many economists already believed. Mussa reviews the typical argument used to ex- plain the difference in real exchange rate variability between floating and fixed ex- change rates-slow adjustment of nomi- nal goods prices relative to nominal ex- change rates. Under floating rates, the nominal exchange rate adjusts instantane- ously to new information while goods prices may adjust more slowly. As a result, the real exchange rate is more variable under a floating than under a pegged ex- change rate regime. While alternative sto- ries may be told to explain the higher vol- atility of real exchange rates under float- ing, the research to date indicates that the nominal exchange rate regime matters. If it does, we would expect investors to have preferences regarding fixed or floating ex- change rates. The simple fact that real ex-

448 ECONOMIC INQUIRY

change rates are more variable under a float does not necessarily imply that risk averse investors would prefer fixed ex- change rates. We now turn to an examina- tion of the distribution of returns under fixed and floating exchange rates.

II. DESCRIPTIVE STATISTICS OF RETURN DISTRIBUTIONS

We use the same method to evaluate the distribution of returns under fixed and floating rates for both samples: the pure foreign exchange returns and the realized returns on foreign stock investments. We first calculate four descriptive statistics of the returns: the mean, standard deviation, skewness, and kurtosis. The distributions are evaluated for both U.S. and foreign in- vestors, but only the U.S. distributions are reported here in order to save space. As will be seen below, there is considerable evidence of the non-normality of the re- turns. Furthermore, it is obvious that there are no truly fixed exchange rates in our sample. The fixed rate period was charac- terized by a greater probability of large but infrequent exchange rate changes, while the floating rate period was charac- terized by many small changes.

Pure Foreign Exchange Returns If S,, is the spot exchange rate of U.S.

dollars per unit of foreign currency i at the end of the month, and nt is the U.S. infla- tion rate, then the percentage change in the exchange rate per month in real dollar terms is

A

The exchange rate and inflation data are taken from the International Monetary Fund’s International Financial Statistics data tape. The fixed rate period is defined as the period from January 1961 (the ear- liest month stock price data are available) to March 1971. The stochastic dominance

program used below requires that an equal number of observations be used for each period, so the floating period data run from October 1978 to December 1988 (the most recent period available for all stock prices used). Our sample includes the exchange rates of twelve countries: Austria, Belgium, France, Germany, Italy, Japan, the Netherlands, Norway, South Africa, Spain, Switzerland and the United Kingdom. Table I gives estimates of the mean, standard deviation, skewness, and kurtosis for the monthly exchange rate changes from the U.S. investor’s perspec- tive. The last row of Table I includes sta- tistics for an equally weighted portfolio of all the currencies in the table.

Table I suggests that the distributions changed considerably between the pegged and floating rate periods. With the excep- tion of Japan, the mean of the distribution is higher for the fixed period and the stan- dard deviation is higher for the float. Based on mean and variance alone, we ex- pect U.S. investors to have a strong pref- erence for the distribution of returns expe- rienced under the fixed exchange rate re- gime.

Table I also illustrates the non-normal- ity of the distribution of exchange rate changes. The kurtosis statistic for a normal distribution is expected to have a value of zero. We find that kurtosis is much greater than that under fixed exchange rates, sug- gesting a distribution more peaked than normal; the kurtosis statistics for the float- ing period are positive, but much lower. Furthermore, the skewness statistic indi- cates that the fixed rate period distribu- tions are also more skewed than those for the floating rate period. In summary, our evidence supports the intuitive conclusion that the fixed rate period was character- ized by a greater probability of large ex- change rate changes, while the floating rate period was characterized by many small changes. Since exchange rates are never truly fixed, the question is which distributions would investors prefer?

MELVIN & ORMETON: EXCHANGE RATE SYSTEMS 449

TABLE I Descriptive Statistics-Exchange Rate Changes for U.S. Investors (Fix [1/61-3/71] Listed First, Float [10/78-12/88] Listed Second)

Country Mean Sta-Dev. Skewness Kurtosis

Austria

Belgium

France

Germany

Italy

Japan

Netherlands

Norway

S. Africa

Spain

Switzerland

U.K.

All 12 Currencies

-.002561 -.003097

-.002584 -.005655

-.003540 -.006873

-.001450 -.003353

-.002621 -.008077

-.002602 -.000642

-.002190 .003648

-.002606 -.006380

-.002577 -.011723

-.003744 -.008156

-.002588 -.003601

-.003764 -.004834

-.002735 -.005503

.0087

.0374

.0091

.0383

.0127

.0362

.0120

.0376

.0087

.0322

.0091

.0380

.0105

.0378

.0088

.0306

.0091

.0477

.0151

.0308

.0094

.0416

.0146

.0361

.0091

.0322

-3.0071 .1704

-2.8977 ,3530

-4.9596 .la04

-.3031 .3808

-2.9765 .2398

-2.8838 .4293

-.4802 .1221

-2.7686 .43%

-3.1065 -.2741

-6.5132 .4822

-2.7601 .2600

-6.0105 .7190

-2.8676 .3751

7.9495 .2966

7.2459 .5888

31.7510 6074

6.9023 .3381

7.6193 .1761

7.1111 .0761

11.6142 1.8648

6.9570 .5262

8.0345 5.1863

53.2251 .4900

6.9886 3192

46.7177 1.5765

6.8735 .1191

Note: Only for South Africa and the 12 currency portfolio is the difference between the means for fived and floating rates statistically significant at the 5% level. All of the differences between the standard deviations are statistically significant at the 5% level.

Table I is based on the point of view of U.S. investors holding foreign currency. We do not report descriptive statistics for other countries’ investors due to space constraints. However, the evidence is gen- erally similar to that found for U.S. invest- ors.

Returns to Holding Foreign Stocks The previous section analyzed the dis-

tribution of returns to the international in- vestor holding an open position in a for- eign currency. While such pure foreign ex- change returns are interesting and provide a basis for comparison to earlier studies,

450 ECONOMIC INQUIRY

they are likely to be misleading. Generally we expect the typical international in- vestor to hold an earning asset in foreign currency. We will now examine the distri- bution of returns on positions in shares of foreign stock. For instance, the domestic return for a U.S. investor holding country i stock shares is

where R , , is the nominal share price ap- preciation in month t, in country i.

Stock prices are recorded on a national market index basis by the IMF and are listed on the International Financial Statis- t ics data tape. Stock price data are avail- able for seven of the twelve countries con- sidered in the last section. Table I1 reports the descriptive statistics for the real re- turns to U.S. investors holding foreign shares. As before, we examine the individ- ual country returns and the return on an equally weighted portfolio of foreign stocks. In all cases except Japan, the float- ing exchange rate returns have a higher mean and a higher standard deviation. A U.S. investor holding Japanese shares would have realized a higher standard de- viation over the fixed rate period than was realized under floating exchange rates.

Table I1 is based on the point of view of U.S. investors holding foreign stocks. As with the currency returns, we do not re- port descriptive statistics for other countries’ investors due to space con- straints. However, the evidence is gener- ally similar to that for U.S. investors.

111. GENERALIZED STOCHASTIC DOMINANCE METHODOLOGY

In order to provide a ranking of distri- butions, we use the most flexible of the commonly used stochastic dominance cri- teria: generalized stochastic dominance (GSD) developed by Meyer [1977a]. GSD is a generalized version of first, second, and third degree stochastic dominance, as

well as stochastic dominance with respect to a function. (For discussion and applica- tions, see McCarl [1988], Meyer [1977b], and Raskin and Cochran [1986].)

The GSD approach begins with the as- sumption that the group of investors under consideration is made up of indi- viduals who are expected utility maximiz- ers and whose preferences can be repre- sented by a von Neumann-Morgenstern utility function, u(x). Groups of investors are defined by placing lower and upper bounds on the Arrow [1971]-Pratt [1964] measure of absolute risk aversion. In par- ticular, let U[rl(x),r2(x)] be the group of in- vestors whose expected utility functions satisfy

for all x . That is, U[rl(x),r2(x)] is the subset of all investors whose risk preferences are bounded above and below by risk aver- sion functions rl(x) and r2(x) respectively. By varying r1(x) and r2(x) we can vary the group of investors under consideration.

Given a description of a group of in- vestors, we say that the distribution of re- turns under fixed exchange rates, F(x), sto- chastically dominates the distribution of returns under floating exchange rates, G(x), if and only if expected utility under F(x) is greater than expected utility under G ( x ) for all investors in the group. For- mally, F(x) stochastically dominates G(x) (G(x) stochastically dominates F(x)) if and only if

(3) f [G(x)-F(x)]u’ (x)dx 2 0 ( 50) a

for all investors in the group

The condition stated above requires a consensus by all investors in the group de- fined by r l ( x ) and r2(x); however, checking

U[r,(x),r2(x>l.

MELVIN & ORMISTON EXCHANGE RATE SYSTEMS 451

TABLE 11 Descriptive Statistics-Share Price Changes for U.S. Investors

(Fix [1/61-3/71] Listed First, Float [10/78-12/88] Listed Second) Country Mean S ta-Dev. Skewness Kurtosis

Austria -.000563 .0484 4.4471 35.0154 2.8922

Germany -.001234 .0490 .6271 2.0195 .003121 .0573 -.0908 1.0586

-.003792 .0606 1.2266

Italy

Japan

-.005917 .0460 .4337 .6576 .011067 .0783 .1524 .9311

-003371 .0701 -.1752 4.0187 .013964 ,0565 .2558 -.3075

Netherlands -.001233 .0411 -.1732 .0828 .005477 .0543 -.1794 .9290

Spain

U.K.

All 7 Stocks

.005517 .0353 -.7916 -.7916 ,008230 .0789 .1946 1.5492

-.000308 .0461 -.4970 .5838 .007438 .0544 .1368 1.1331

-.000005 .0261 -.1515 1.0090 .007581 .0451 .1700 .a690

Note: Only for Italy is the difference between the means statistically significant at the 5% level. All of the differences between the standard deviations are statistically significant at the 5% level.

for such a consensus is impossible since there is an infinity of agents with expected utility functions in this group. Fortunately, we can circumvent this problem if we can identify the utiIity function within the specified interval, denoted by uo(x), that is most likely not to prefer F(x) to G(x) . If it can be said for this investor that expected utility under F(x) is greater than under G(x), this implies it must be so for all other investors with utility functions in the specified interval.

The GSD theorem proved by Meyer [1977a] gives u s a simple way to find u&) and, thus, to rank the distributions. According to the theorem, the expected utility function that minimizes

must be such that

ro(x) = Y ~ ( X ) if

h

f [G(x) -F(x) ]u' (x)dx < 0, Y

and

Since r0(x) completely represents a given investor's preferences, we can find uo' and check if the expected utility from distribu- tion F(x) is greater than the expected util- ity from distribution G(x) . Thus, we deter- mine whether F(x) stochastically domi-

452 ECONOMIC INQUIRY

nates G(x) for all investors in the group

In order to implement the GSD theo- rem, we must (i) estimate F(x) and G(x), and (ii) specify T ~ ( X ) and T ~ ( X ) and calculate expected utilities. Since we do not know the functional form underlying the return distributions, we use the data described in section I1 of this paper to generate "empir- ical" distributions. These empirical distri- butions are used to approximate F(x) and G(x). (Since we have no priors as to the nature of the true distribution, statistical tests for goodness of fit do not exist.)

We use the GSD program developed by

wr1(4 ,T2Wl .

return of 9.5 percent, while an individual with a risk aversion parameter of 1 0 would be indifferent between the risky op- portunity and a certain return of 5.7 per- cent. Thus, a risky aversion parameter of 10 indicates extremely high risk aversion. In fact, in a survey of the literature dealing with empirical investigations of the Arrow-Pratt measure of absolute risk aversion, Raskin and Cochran [1986] find that most researchers consider a risk aver- sion parameter between 5 and 10 to indi- cate strong risk aversion.

IV. EMPIRICAL RESULTS

McCarl [1988] to order the return distribu- Table Iv displays the second degree sto-

lower bounds on the risk preference inter- investors. To Save space, we do not report Val can be either increasing or decreasing the SSD rankings for non-U.S. investors; functions of the random variable, for com- however, the results are much the same. putational we that they are In ten of the thirteen cases for the currency

returns, fixed exchange rates are pre- constants. That is, we assume that

tion'. in genera', the upper and chastic dominance (SSD) rankings for U.S.

(4) uo(x)= -PX T > 0

= x r = O .

This particular specification of upper and lower bounds has become standard in the literature dealing with GSD.

Before proceeding to the results, we must have some idea of what values of the risk aversion parameter, r, represent ex- tremely risk averse behavior. One way to illustrate the meaning of specific values of r is to calculate certainty equivalents. Sup- pose, for example, we consider the cer- tainty equivalent of a risky investment yielding an annual rate of return of 20 per- cent with probability .5 and a zero rate of return otherwise. Table I11 reports the cer- tain return required for indifference be- tween the certain payoff and the risky in- vestment for a variety of values of T. For instance, an individual with a risk aver- sion parameter of unity would be indiffer- ent between the risky opportunity with an expected return of 10 percent and a certain

ferred, while for Japan, Spain, and-the U.K. the ranking is not unanimous. The stock returns all yield ambiguous rank- ings, except for the Japanese stocks where the distribution of returns under floating exchange rates is preferred. The ambigu- ous rankings suggest that risk averse in- vestors will not all agree on the preferred exchange rate regime. To explore the na- ture of this disagreement we must turn to generalized stochastic dominance.

Table V gives the preferences of U.S. in- vestors over different ranges of risk aver- sion for the pure foreign exchange returns. By varying the degree of risk aversion, we can observe the switch in preference from one regime to another over different classes of investors. For all cases except Japan, from the risk neutral investor through those with a risk aversion param- eter of 10, fixed exchange rates are pre- ferred. This indicates that only extremely risk averse investors would prefer floating exchange rates when holding currencies. In the case of Japan, at low levels of risk aversion the float is preferred. For abso-

MELVIN & ORMISTON: EXCHANGE RATE SYSTEMS 453

TABLE I11 Certainty Equivalent of a Risky Opportunity

With an Expected Return of 10% r Certainty Equivalents (%)

1 5 10

9.5 7.6

5.7

TABLE IV Preferences for Fixed versus Floating Exchange Rates Based on

Second Degree Stochastic Dominance for U.S. Investors Currency or Stocks of: Currency Stocks

Austria Fix Belgium Fix NA France Fix NA Germany Fix * Italy Fix * Japan Float Netherlands Fix Norway Fix NA S. Africa Fix NA Spain * Switzerland Fix NA U.K.

*

* *

*

* *

All 12 Currencies Fix NA All 7 Stocks NA *

*denotes ambiguous choice NA denotes not applicable

lute risk aversion greater than three, fixed exchange rates are preferred when hold- ing yen. This is the case where the mean return is higher under the float.

Table VI reports the preferences for non-U.S. investors, that is, investors who are holding equally weighted portfolios of twelve foreign currencies (all other curren- cies in the table plus the US. dollar). In most cases, fixed exchange rates are pre- ferred by all risk averse investors. How-

ever, in three cases the results differ. Ital- ian investors with absolute risk aversion parameters of 8.7 or more prefer floating exchange rates. For investors from the Netherlands, all risk averse investors would prefer the distribution of returns under the float. South African investors prefer floating exchange rates up to a low level of absolute risk aversion (r = 0.5) and then switch their preference to fixed ex- change rates.

454 ECONOMIC INQUIRY

TABLE V U.S. Investor Preferences as a Function of Absolute Risk Aversion for Currency

Portfolios Under Fixed or Floating Exchange Rates Range where fixed rates Range where float is preferred

Currency of: to fixed rates preferred to float

Austria Belgium France Germany Italy

Japan Netherlands Norway S. Africa Spain Switzerland U.K. All 12 Currencies

0 - 3.0

0 - 10 0 - 10 0 - 10 0 - 10 0 - 10

3.0 - 10 0 - 10 0 - 10 0 - 10 0 - 10 0 - 10 0 - 10 0 - 10

TABLE VI Non-U.S. Investor Preferences as a Function of Absolute Risk Aversion for

Currency Portfolios Under Fixed or Floating Exchange Rates Range where float is preferred Range where fixed rates

Investor of: to fixed rates preferred to float

Austria Belgium France Germany Italy

Japan Netherlands Norway S. Africa Spain Switzerland U.K.

8.7 - 10

0 - 10

0 - 0.5

0 - 10 0 - 10 0 - 10 0 - 10

0 - 8.7

0 - 10

0 - 10 0.5 - 10

0 - 10 0 - 10 0 - 10

Note: Investors of each country hold an equally weighted portfolio of the currencies of the other countries in the table plus the US. dollar.

MELVIN & ORMISTON: EXCHANGE RATE SYSTEMS 455

Two points may be made with regard to the results listed in Tables V and VI. First, investors in different countries will not all agree on the preferred exchange rate regime. Second, investors in a single country may disagree on the preferred ex- change rate regime. For example, moder- ately risk averse U.S. investors holding Japanese yen prefer the distribution of re- turns associated with floating exchange rates, but those investors exhibiting a greater degree of risk aversion prefer fixed exchange rates.

The rankings for U.S. investors holding foreign stocks are listed in Table VII. Esti- mating the stochastic dominance rankings over different ranges of risk aversion, we find a preference for floating exchange rates at low to moderate levels of risk aversion for all portfolios and a shift in preference to fixed rates at high levels of risk aversion in five cases. This finding suggests that critics of floating exchange rates may overstate their case when ar- guing that investors prefer the distribu- tion of returns under fixed exchange rates. As a general statement applying to U.S. investors, this is only true of very risk averse investors holding concentrated portfolios comprised of stocks of either Austria, Germany, Italy, the Netherlands, or Spain. Those holding portfolio diversi- fied across all seven countries prefer a floating regime over the full range of risk aversion considered.

Table VIII explores shifts in preferences over different ranges of risk aversion for non-U.S. investors holding portfolios of stocks of seven countries (the other coun- tries in the table plus the U.S.) Floating exchange rates are preferred over all ranges, except for the U.K. British invest- ors, at a high level of absolute risk aver- sion (r = 84, prefer fixed exchange rates. The results of Table VIII generally indicate that it is simply not accurate to claim that investors prefer the distribution of returns realized under fixed exchange rates.

The real returns to holding foreign shares of stock provide a much different result than did the pure foreign exchange returns. The foreign exchange returns yielded a preference for fixed exchange rates by all risk averse investors for most portfolios and countries. Once the in- vestor is assumed to hold securities de- nominated in foreign currency, rather than just actual foreign currency, the results change dramatically. Now, floating ex- change rates are generally preferred by in- vestors of most countries. When prefer- ences switch as risk aversion changes, fixed exchange rates are preferred by only the most risk averse investors.

The different results for investors with open positions in foreign stocks compared to investors with open positions in curren- cies reflect the fact that under a floating regime, exchange rate changes typically reduce the variability of stock returns across countries. We expect a greater de- gree of exchange rate depreciation in a country where nominal returns on stocks or bonds exceed those of other countries. (However, as noted by Adler and Dumas [1983], exchange rate variability tends to be greater than stock price variability, and changes in exchange rates do not offset changes in stock prices completely.)

V. CONCLUSIONS

We now return to the initial question that motivated this study: Did floating ex- change rates increase the riskiness of in- ternational investment positions so that investors would have preferred the distri- bution of returns under fixed exchange rates? In our analysis of pure foreign ex- change returns, the answer was generally "yes." If we consider only the investor speculating in the foreign exchange mar- kets, we conclude that fixed exchange rates are preferred. While this result is in- teresting to compare to previous work, there is good reason to doubt its impor-

456 ECONOMIC INQUIRY

TABLE VII U.S. Investor Preferences as a Function of Absolute Risk Aversion for Stock

Portfolios Under Fixed or Floating Exchange Rates Range where float is preferred

Stocks of: to fixed rates preferred to float

Austria 0 - 5.5 5.5 - 10

Range where fixed rates

Germany Italy

0 - 7.7

0 - 8.4

Japan 0 - 10

Netherlands Spain

0 - 9.8

0 - 1.1

7.7 - 10

8.4 - 10

9.8 - 10

1.1 - 10

U.K. 0 - 10

All 7 Countries 0 - 10

TABLE VIII Non-U.S. Investor Preferences as a Function of Absolute Risk Aversion for Stock

Portfolios Under Fixed or Floating Exchange Rates Range where float is preferred Range where fixed rates

Investor of: to fixed rates preferred to float

Austria Germany Italy

Japan Netherlands Spain U.K.

0 - 10

0 - 10 0 - 10 0 - 10

0 - 10 0 - 10

0 - 8.8 8.8 - 10 ~~ -~

Note: Investors of each country hold an equally weighted portfolio of the stocks of the other countries in the table plus US. stocks.

tance. Few investors would hold substan- tial levels of a non-earning asset like for- eign currency.

Considering the more typical investor’s behavior of holding open positions in for- eign securities, where exchange rate changes serve to reduce the riskiness of investing in different countries, we con- clude that floating exchange rates are pre- ferred. Only for high degrees of risk aver-

sion do some investors’ preferences switch to fixed rates.

We conclude, then, that floating ex- change rates did not increase the riskiness of international investment positions to the point where investors should prefer the distribution of returns under fixed ex- change rates. Only investors with a rela- tively high aversion to risk would prefer fixed to floating exchange rates.

MELVIN & ORMISTON: EXCHANGE RATE SYSTEMS 457

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