Modeling international financial markets.

• Author: Dumas, Bernard

A large number of issues in the field of international economics depend on one crucial question: Is the worldwide financial market integrated, or is it made up of a number of segments with imperfect capital mobility among them?

To try to decide this issue, some macroeconomists have derived clues from macroeconomic variables. Feldstein and Horioka,[1] for example, have examined the behavior of national savings and investment, testing for complete segmentation. But high correlations found between savings and investment could be compatible as easily with full integration of capital markets.

A second macroeconomic avenue is based on the correlation among consumption rates across countries. Under integration and certain other conditions, national consumption rates ought to be correlated perfectly. In fact, the correlations are very low (in many cases lower than for national production rates). But the correlations may be low because financial markets, although integrated, are incomplete.

Evidence from the composition of aggregate portfolios of national investors also indicates that portfolios are not diversified worldwide nearly as much as they should be in a fully integrated world. This fact is called the "home-equity bias."

In principle, the best way to decide the matter of integration versus segmentation is to look at prices in financial markets. If similar assets - or similar dimensions of risk - traded in different places do not receive the same price, then full integration does not exist. Furthermore, data on prices in the financial market are plentiful, more so than macroeconomic data.

However, the approach based on financial-market prices necessarily relies on some model of the relationship between expected rerum and risk. Deviations from the pricing model act as "noise" in the data, and prevent any clear empirical conclusion on the issue of segmentation. Therefore, it is important to have a model that provides a decent degree of explanation of the worldwide cross section of asset returns at any given time. Here I discuss two aspects of such a model on which some progress has been made recently.

The Pricing of Exchange Risk

Prima facie, it would seem that randomly fluctuating exchange rates could be a cause of market segmentation, since investing abroad brings returns that are subject to exchange risk, whereas investing at home does not. Exchange risk is important mainly because deviations from Purchasing Power Parity (PPP) - for example, movements in real exchange rates - cause investors who consume in different places to adopt different attitudes toward the same securities.

However, currency-based financial instruments provide a way of hedging exchange risk, at a price. The hedge is...