Is an Optimal Currency Area an Optimal Portfolio?

Abstract: This paper will analyze the construction of an optimal currency area using mean variance portfolio analysis, in order to determine what would have been the most stable monetary union for the European Union prior to the complete transition to the Euro currency on January 1, 2002. The analysis calculates the minimum variance portfolio of the potential European Union members by using there sovereign bond yield to maturity as a proxy for the return and variance of the asset. The mean variance model used was subject to variable upper and lower bound constraints of the portfolio weights, that dependant on the size of the country’s GDP to total GDP of the portfolio. The data obtained from the calculation of the efficient minimum variance portfolios indicates that the Eurozone did not form an optimal currency area that provided the most stability. The analysis also determined that Greece, Portugal, and Ireland were the countries that were most frequently left out of the optimal minimum variance portfolio, implying that they could contribute to instability within the optimal currency area. Even though the data period is from 1993 until 2001 this analysis accurately represents potential countries that would cause instability within the currency union, currently seen in the 2010/2011 sovereign debt crisis.