Expected utility and portfolio selection: an econometric study of Pakistan's commercial banking sector

Abstract

This paper attempts to explain the portfolio behaviour of Pakistani banks. Several expected utility models are developed and applied to semi-annual data for the period from 1997 to 2012. The expected utility model commonly reduced to the mean-variance model, of bank portfolio behaviour under risk stems from the works of Hicks, Tobin and Markowitz. According to this approach, the determinants of alternative portfolios can be assessed by the trade-off between their expected return and valuation risks, where the former is the mean of the probability distribution of return and the latter is usually approximated by the variance of that distribution. Different theoretical restrictions have been tested to explain the Pakistani banking portfolio including symmetry and homogeneity of the interest rate matrix. Empirical evidence suggests that, in general, changes in interest rates do explain the changes in the portfolio of these units, but the availability of funds and other policy variables were found to be more important.