Some implications of international portfolio diversification
Description
This dissertation uses a continuous time, consumption--portfolio choice model to investigate three questions in international finance. The model is solved using the stochastic optimal control techniques pioneered by Merton The first question is the differential effect of exchange rate variability on the foreign trading. In the conventional view, either nominal or real exchange rate variability makes foreign trading differentially risky compared to domestic trading. It is shown that this result depends on systematic habitat dependencies in portfolio structure. The sources of country specific portfolio differencies are explored The second question is currency substitutability. Assuming economic agents do hold foreign monies for both their asset and transactions properties, the question is how elastic foreign money demand is with respect to changes in domestic interest rates. It is shown that contrary to the usual currency substitution arguments, foreign transactions balances of domestic agents do not generally respond to changes in domestic interest rates. Even though transactions balances in foreign monies are held, they are not substitutable in that they do not respond to changes in domestic rates. The determinants of the substitutability of broadly defined foreign money balances are derived The last issue addressed is the effect current account imbalances might have on exchange rates in a monetary model. It is shown that international asset portfolio structures differs by country due to the interaction of stochastic labor incomes and Phillips curves. When wealth is redistributed, as by current account imbalances, this can cause exchange rate movements in a monetary model of exchange rate determination which incorporates portfolio formation. Surplus countries' exchange rates will tend to appreciate; those with current account deficits will tend to have depreciating currencies