INTERNATIONAL FINANCE - INTERNATIONAL FINANCIAL MANAGEMENT

1. PORTFOLIO THEORY
Dr. Mohamed Kutty Kakkakunnan
Associate Professor
P G Dept. of Commerce
N A M College Kallikkandy
Kannur – Kerala - India

2. P O R T F O L I O T H E O R Y
 The Portfolio Balance approach is a modern theory based
on the relationship between the relative price of bonds
and exchange rates
 Argues that exchange rate is determined by portfolio
decisions of all investors
 Foreign exchange is a financial asset and the demand for
foreign exchange arises from the portfolio decisions of all
investors
 Exchange rates between freely traded currencies are
influenced more by capital flows than by trade flows
 Rejects the proposition that interest bearing securities can
be perfectly substituted internationally to attain a uniform
real rate of interest among nations

3.  Risk factors and current account imbalances may have
an important role to play in exchange rate changes
 Any change in the economic conditions of a country
will have a direct impact on the demand and supply for
the domestic and the foreign bond
 This shift in the demand/supply for bonds will in turn
influence the exchange rate between the domestic and
foreign economies
 The key advantage of the portfolio approach when
compared to traditional approaches is that the
financial assets tend to adjust considerably faster to
news economic conditions than tradeable goods

4. Investors desire for diversified portfolios which include
domestic and foreign assets
Equilibrium exchange rate is one of the many prices that
jointly equate demand and supply for asset in
international financial markets
This theory by establishing relationship between supply
and demand functions for bonds and equilibrium
conditions that equate supply and demand bonds show
how bond markets reach in equilibrium
Also shows how changes in bond supplies and demand
affect the interest rate and exchange rates
(consequences)
This approach also argues that the central bank can
through changing the supply of bonds can influence
the interest rates and exchange rates

5. The central bank by reducing the supply of bonds
can increase the demand over supply which will
increase the demand for bonds and lower
interest rates
Interest rate reduction affects investments, output
and prices that will affect the exchange rate.
According to portfolio theory, exchange rate can
stray (move) at least in the short run from its long
run PPP equilibrium
Nevertheless, based on empirical evidence, the
portfolio balance approach is not an accurate
predictor of exchange rates.