International Capital Constraints and Stock Market Dynamics

Abstract

In order to explain cross-country differences in the effects of capital market liberalization, this paper proposes a model of international asset markets in which investors in different countries each face constraints on portfolio choice. The model demonstrates that liberalization, i.e. the lifting of constraints, can increase or decrease the liberalized stock market’s volatility, depending on how severely the constraint was binding before being removed, and whether markets are fully or only partially liberalized. The same factors also determine whether a market’s correlation with world markets increases or decreases, thus linking correlation effects to the magnitude of capital inflows post-liberalization.