Financial Institutions and International Capital Movements: Portfolio Selection or Trade Finance?

Abstract

Earlier studies of international short-term capital movements have been based on the interest rate parity theory, a flow theory (see, for example, [11, 12]). This approach can be criticized for its implications that the solution to the utility maximizing problem results in either a corner solution or indifference among assets, and that the interest rate differential measured between two countries is equal to the discount (or premium) on the currency [8, p. 512] . More recent studies, [2, 3, 9] have attempted to meet these objections with the incorporation of various aspects of portfolio theory. However, most studies continue to use interest rate differentials as a major argument in the determination of capital movements, one implication of which is that capital flows into a nation as readily as out, a proposition not unambiguously supported by the findings to be presented in this paper. Second, the aggregate data used obscures the distinction between the two major decision-making units involved in these transactions. Financial institutions, most notably banks, typically cover their operations and avoid speculation. NonElnancial institutions, characteristically multinational firms, are not subject to the legal requirements that face financial institutions and their speculative activity is often cited for the volatility of short-term capital movements.