Consumption Basket, Exchange Risk, and Asset Demand

Abstract

Foreign exchange risk and hence the demand for foreign assets depend on the objective and habitat of investors. The investment objective, in turn, is contingent upon how the consumption basket or its price is defined. If the investor is “domestic” in the sense that he or she spends all income on domestic goods, then the domestic price index should be used in defining the investment objective in real terms, regardless of whether returns are generated at home or abroad. However, for an investor who consumes a mix of foreign and home products, or for multinational firms with extensive operations outside their home countries, some sort of world price reflective of the relative importance of home and foreign goods in their consumption basket is the proper deflator.