Karen K. Lewis

Puzzles in international financial markets

Publisher Summary This chapter focuses on two puzzles related to international financial markets. The first puzzle concerns explanations for deviations from uncovered interest parity or, equivalently, excess returns on foreign relative to domestic deposits. The chapter considers various explanations for the puzzle. First, under standard assumptions about rational expectations, ex post excess returns just equal the markets true expected excess returns plus a forecast error that is unpredictable ex ante. The second puzzle is called “home bias,” the phenomenon that domestic investors hold too little of their portfolios in foreign assets. The chapter considers this puzzle with the two models used to examine the foreign exchange risk premium. Both models suggest that domestic investors hold too little of their wealth in the form of foreign assets. The first type of model, based upon CAPM, implies that domestic investors should hold foreign assets in their portfolio in a fraction that depends upon their degree of risk aversion, among other variables. The second type of model, based upon complete markets, gives predictions about consumption risk-sharing.

Do stationary risk premia explain it all?: Evidence from the term structure

Most studies of the expectations theory of the term structure reject the model. However, the significance of the rejections depend strongly upon the form of the test. In this paper, we use the pattern of rejection across maturities to back out the implied behavior of time-varying risk premia and/or market forecasts. We then use a new technique to test whether stationary risk premia alone can be responsible for these rejections. Surprisirj1y, this test is rejected for short maturities up to 6 months, suggesting that time-varying risk premia do not explain it all. We also describe hew this method can be used to test other asset pricing relationships.

Can learning affect exchange-rate behavior?: The case of the dollar in the early 1980's

This paper demonstrates that a change in parameters of the money market that is not immediately understood will affect the behavior of exchange-rate forecast errors while the market is learning. The analysis is applied to the behavior of U.S. dollar-German mark forecast errors during the early 1980s when the market appeared to systematically underpredict the strength of the dollar. Consistent with this observation, empirical estimates of implied forecast errors based upon Bayesian learning suggest that forecast errors would have been on-average negative during the period as the market came to realize the increase in U.S. money demand.

Why do stocks and consumption imply such different gains from international risk sharing

Abstract Estimates of the gains to international risk-sharing based upon stock returns tend to find dramatically higher gains than do estimates from consumption-based models. In this paper, I examine the reasons for these differences. Using a common theoretical framework for both approaches, I find that the differences are largely due to the much higher variability of stock returns and its implied intertemporal substitution in marginal utility. Also, contrary to conventional wisdom, the differences in gains from the two approaches do not arise from treating stock returns as exogenous rather than endogenous.

Testing the portfolio balance model: A multi-lateral approach

Abstract This paper estimates outside bond demand equations from the portfolio balance model of exchange rate determination for five currencies. The approach used in this paper differs from other structural studies of the portfolio balance model in two fundamental ways. First, while previous studies limit the portfolio choice to domestic assets relative to a composite foreign asset, the model analyzed in this paper decomposes the foreign asset by currency. Second, exploiting the cross-equation correlation that arises from this decomposition provides more efficient estimates of the asset market parameters.

The persistence of the `peso problem' when policy is noisy

The ‘peso problem’, the markets belief that a discrete event may occur, has frequently been blamed for the persistence of on-average mistaken forecasts of macroeconomic variables. This paper demonstrates how beliefs that a policy process may have switched can induce apparent ex post biased forecasts of exchange rates even after the switch has occurred . Furthermore, during this ‘peso problem’ period, exchange rates may appear to contain a speculative bubble component since they will systematically deviate from the levels implied by observing fundamentals ex post; and the conditional variance of exchange rates will exceed the variance implied by observing fundamentals.

Are countries with official international restrictions 'liquidity constrained'?

Abstract In this paper, I empirically examine consumption smoothing behavior across a broad group of countries using a unique data set that indicates whether residents in a country face an official government restriction. I then ask whether the ex ante consumption movements among restricted countries differ from those of unrestricted countries. To gauge the departure from standard consumption smoothing, I use the Campbell and Mankiw (‘Consumption income, and interest rates: Reinterpreting the time series evidence’, In: O.J. Blanchard and S. Fischer, eds., NBER macroeconomics annual, 1989 (MIT Press, Cambridge, MA, 1989) and ‘The response of consumption to income: A cross-country investigation’ European Economic Review 35, 723–756, 1991) approach of regressing consumption growth on income growth and instrumenting with lagged variables. Interestingly, I find that consumption growth for residents in countries that impose international restrictions have a significantly higher coefficient on income growth than do residents in countries without those restrictions. Thus, a greater proportion of consumers facing international restrictions appear to act as though they are liquidity constrained according to the Campbell and Mankiw approach. I also discuss alternative interpretations that do not depend upon liquidity constraints.

Inflation risk and asset market disturbances: The mean-variance model revisited

Abstract This paper empirically re-investigates the international CAPM model. In constrast to previous studies by Frankel (1982) and Frankel and Engel (1984), the estimation model does not require that there be no asset market disturbances. Also, rather than requiring purchasing power parity or that the only source of inflation uncertainty arise from a weighted average of exchange rate changes as in the previous studies, inflation risk is simply measured as the uncertain component in the consumer price index of each country. To allow for these additional sources of uncertainty, an alternative estimation method is derived to identify the covariance constraints.

Differences of Opinion and International Equity Markets

We develop an international financial market model in which domestic and foreign residents differ in their beliefs about the information content in public signals. We determine how informational advantages by domestic investors in the interpretation of home public signals impact equity markets. We evaluate the ability of our model to generate four international finance anomalies: (i) the co-movement of returns and capital flows; (ii) home-equity preference; (iii) the dependence of firm returns on home and foreign factors; and (iv)abnormal returns around foreign firm cross-listing in the home market. Their relationships with empirical differences-of-opinion proxies are consistent with the model.

Should the Holding Period Matter for the Intertemporal Consumption-Basedcapm?

Empirical studies of the restrictions implied by the intertemporal capital asset pricing model across different asset markets have found conflicting evidence. In general, restrictions from this model have been rejected over short holding periods, but not over longer holding periods such as a quarter. This paper asks whether an auxiliary assumption implicit in these tests could be responsible for the observed pattern of rejections. The auxiliary assumption requires that covariances of returns with consumption move in constant proportion over time. The paper first describes how this condition may break down within the context of a general equilibrium pricing relationship. Then, the condition is tested empirically using data on foreign exchange, bonds, and equity returns. Interestingly, the pattern of consumption covariances in foreign exchange and bonds indeed match the pattern of rejection in the intertemporal asset pricing relationship.