The Portfolio Theory of Exchange Rates Then and Now

Abstract

In the early 1970s, the portfolio theory of exchange rates with rational expectations was introduced to explain the behavior of floating exchange rates. While attractive in principle, the approach failed along with other theories to provide empirically convincing results. Over the years, the theory has been extended to a general equilibrium setting and modified to include central bank intervention and non‐rational expectations. More recently, it has become a platform for the micro‐structural approach emphasizing order flows, which shows increasing promise as an empirical explanation of exchange rate behavior.