We model interest rate and portfolio determination under the risk of real currency devaluation taking into account risk aversion on the part of investors. A simple extension of the Friedman-Savage analysis of consumer behavior under uncertainty to a two period, two country setting allows us to explicitly solve for the interest rate premium paid in the risky asset. The model is applied to the 1979-1980 Argentinean experiment with the pre-announced exchange rate. Empirical results suggest that a safety factor, central bank reserves as a fraction of M2, is closely related to the net ex ante and ex post arbitrage differentials in favor of Argentina relative to the United States. (JEL D8).
ASJC Scopus subject areas
- Economics and Econometrics