International Asset Research Articles

Current Account Deficits During Heightened Risk: Menacing or Mitigating?

Large current account deficits, and the corresponding reliance on capital flows from abroad, can increase a country’s vulnerability to periods of heightened risk and uncertainty. This paper develops a framework to evaluate such vulnerabilities. It highlights the central importance of two financial factors: income on international investments and changes in the valuations of those investments. We show how the characteristics of a country’s international investment portfolio ‒ the size of its international asset and liability holdings, their currency denominations, their split between equity and debt exposures, and their return characteristics ‒ affect the dynamics of these financial factors. Then we decompose those dynamics into their drivers and explore how they are affected by domestic and global risk. We apply this framework to 10 OECD economies, showing the flexibility of this approach and how the countries’ different international investment portfolios generate different dynamics in international investment income and positions. These examples, including a more detailed assessment based on an SVAR for the UK, show that a substantial degree of international risk sharing can occur through current accounts and international portfolios. Our framework clarifies which characteristics of a country’s international portfolio determine whether a current account deficit is “menacing” or “mitigating”.

Quantitative Assessment of the Role of Incomplete Asset Markets on the Dynamics of the Real Exchange Rate

I develop a two-country New Keynesian model with capital accumulation and incomplete international asset markets that provides novel insights on the effect that imperfect international risk-sharing has on international business cycles and RER dynamics. I find that business cycles appear similar whether international asset markets are complete or not when driven by a combination of non-persistent monetary shocks and persistent productivity (TFP) shocks. In turn, international asset market incompleteness has sizeable effects if (persistent) investment-specific technology (IST) shocks are a main driver of business cycles. I also show that the model with incomplete international asset markets can approximate the RER volatility and persistence observed in the data, for instance, if IST shocks are near-unit-root. Hence, I conclude that the nature of shocks, the extent of financial integration across countries and the existing limitations on asset trading are central to understand the dynamics of the real exchange rate and the endogenous international transmission over the business cycles.

EXCHANGE RATE RISK EXPOSURE IN ASSET PRICING THEORY

A large number of research papers on relation between currency risk and firms’ value have been published during last several decades. Researches acknowledged that currency risk could be a pricng factor. In this paper we investigate the historical development of models within the pricing theory. Also, we come to conclusion that dynamic, conditional and international asset pricing models were considered among the best for identifying the impact of exchange rate risk in developed and emerging markets. There is certain specific in currency exposure research. In this paper we considered different methodological aspects for identifying the impact of exchange rate and mentioned details of empirical analysis in emerging markets.

Stress testing correlation matrix: a maximum empirical likelihood approach

ABSTRACTStress testing correlation matrix is a challenging exercise for portfolio risk management. Most existing methods directly modify the estimated correlation matrix to satisfy stress conditions while maintaining positive semidefiniteness. The focus lies on technical optimization issues but the resultant stressed correlation matrices usually lack statistical interpretations. In this article, we suggest a novel approach using Empirical Likelihood method to modify the probability weights of sample observations to construct a stressed correlation matrix. The resultant correlations correspond to a stress scenario that is nearest to the observed scenario in a Kullback–Leibler divergence sense. Besides providing a clearer statistical interpretation, the proposed method is non-parametric in distribution, simple in computation and free from subjective tunings. We illustrate the method through an application to a portfolio of international assets.

Jump-diffusion international asset allocation

We examine international asset allocation with jump-diffusion assets in the presence of risky deviations of exchanges rates from purchasing power parity when investors consume both traded and nontraded goods. We show that adding new jump risks to existing diffusion assets does not alter investors’ original optimal portfolios of diffusion assets, as long as diffusion-risk premia remain unchanged. We also show that hedge portfolios against purchasing power parity deviations are integral parts of optimal portfolios for investors from different countries, and they can be constructed by using foreign and domestic inflation-indexed bonds. Moreover, country-specific demand for risky assets can arise from nontraded-good-specific inflation-rate-differential risks.

Global banking, global crises? The role of the bank balance-sheet channel for the transmission of financial crises

We examine whether shocks to leveraged creditors with cross border holdings have an incidence on debtor countries׳ risk of suffering financial turmoil. We construct a new proxy of shocks to international banks׳ balance-sheets using credit ratings and the structure of their international assets. This allows us investigating the effect of (foreign) bank balance-sheet shocks on domestic financial turmoil in a large sample of 146 developed and emerging economies from 1984 to 2011. Our proxies of shocks towards bank balance-sheets are strong predictors of systemic banking crises in their debtor countries. Confirming these results, bilateral bank flows significantly decrease when creditor banks׳ assets are hit by negative shocks, as measured by credit rating downgrades from third-party countries. Short-term liabilities towards global banks appear to increase roll-over and funding risks, thereby amplifying the impact of shocks to foreign lenders’ balance-sheets. Domestic banking sectors vulnerabilities, such as illiquid assets and a low deposit-asset ratio, are found to increase crisis contagion risk. In contrast, a high level of global liquidity attenuates the transmission of shocks to international banks׳ assets to debtor countries.

The Impact of Investability on Asset Valuation

AbstractWe develop an international asset pricing model to measure the impact of investability constraints on asset pricing. For a sample of 18 emerging markets, we use Standard & Poor’s investable weight factor (IWF) to show a 26.33% reduction in the cost of equity capital when non-investable firms become partially investable, with a further 12.51% reduction when partially investable firms become unrestricted. We demonstrate the generality and usefulness of the IWF by examining stocks with global/American depositary receipts and foreign institutional holdings as alternate investability proxies. Our results provide strong evidence of the economic benefits of market liberalization policies.

International Asset Allocation with Regime Switching: Evidence from the ETFs

AbstractWe develop a dynamic investment strategy with Markov regime switching (MRS) in asset allocation with international iShares exchange‐traded funds (ETFs). Using daily ETF data, we show that a portfolio based on the dynamic MRS strategy outperforms one based on static mean‐variance strategies after transaction costs. This dynamic investment strategy not only captures the regime shifts in the highly frequent trading process but also can be practically used with tradable ETFs. We investigate the reasons for predictive misjudgments and assess the contribution of each regime's investment strategy, providing insight into the characteristics of the MRS model and modifying our views on why the MRS strategy outperforms traditional strategies.

Outsourcing in the International Mutual Fund Industry: An Equilibrium View

ABSTRACTWe study outsourcing relationships among international asset management firms. We find that, in companies that manage both outsourced and in‐house funds, in‐house funds outperform outsourced funds by 0.85% annually (57% of the expense ratio). We attribute this result to preferential treatment of in‐house funds via the preferential allocation of IPOs, trading opportunities, and cross‐trades, especially at times when in‐house funds face steep outflows and require liquidity. We explain preferential treatment with agency problems: it increases with the subcontractor's market power and the difficulty of monitoring the subcontractor, and decreases with the subcontractor's amount of parallel in‐house activity.

The End-of-The-Year Effect: Global Economic Growth and Expected Returns Around the World

Global economic growth at the end of the year strongly predicts returns from a wide spectrum of international assets, such as global, regional, and individual-country stocks, FX, and commodities. Global economic growth at other times of the year does not predict international returns. Low growth in the global economy at the end of the year predicts higher returns over the following year. It also predicts the global business cycle. When global economic growth at the end of the year is low, investors expect a worsening of the global business cycle and increase their required returns.

STATE REGULATION OF PENSION ASSETS INTERNATIONAL INVESTING

The goal of this article is to clarify the role of government regulation in international investment asset of accumulating pension funds. The main purpose of state regulation of pension assets international investment is to protect the interests of accumulating pension funds to preserve the value of pension savings. The subject of state regulation of pension assets international investment is the National Commission for the State Regulation of Financial Services Markets. There are the legal, administrative and economic forms of state regulation of international investment of pension assets. Government regulation of pension assets international investment require the additional risks of investing pension assets in international financial markets, which can provide effective balance between benefits and costs for pension funds participants and for state.In the article it is studied the experience of state regulation of assets mandatory funded pension funds international investment in EU countries of Central andEastern Europe. Positive and negative effects of quantitative restrictions on pension assets international investment are shown. Practical recommendations for state regulation of Ukrainian accumulating of pension funds asset international investment are offered.

Trade Network Centrality and the Currency Carry Trade

I uncover an economic source of exposure to global risk that drives international asset prices. Countries which are more central in the global trade network have lower interest rates and currency risk premia. As a result, an investment strategy that is long in currencies of peripheral countries and short in currencies of central countries explains unconditional carry trade returns. To explain these findings, I present a general equilibrium model where central countries’ consumption growth is more exposed to global consumption growth shocks. This causes the currencies of central countries to appreciate in bad times, resulting in lower interest rates and currency risk premia. In the data, central countries’ consumption growth is more correlated with world consumption growth than peripheral countries’, further validating the proposed mechanism.

Determinants of Expected Returns at Public Defined-Benefit Pension Plans

Estimated expected returns are important for pension plans, as they influence many plan characteristics including required asset levels, annual contributions, and the extent of plan under- or overfunding. Yet, there seems to be little prior literature on the factors influencing these estimated future returns. In an attempt to fill this gap, this paper presents the results of a panel analysis of data on the determinants of such returns used by US public defined-benefit (DB) pension plans for the period 2001–2011. As expected, we find that real return estimates by DB public pension funds are positively related to fund size, fund age, international asset diversification, state income, and corruption levels. However, more interestingly and importantly, we document that real return estimates by public US DB pension funds are positively related to cultural measures of individualism and masculinity, and negatively related to uncertainty avoidance. These results should be of much interest not only to scholars and pension benefi ciaries, but also to fund managers, other capital market participants, and policymakers.

Monetary Policy Under Commodity Price Fluctuations

AbstractThis paper discusses monetary policy in a New Keynesian open economy subject to commodity price fluctuations. We review theoretical results that imply that stabilizing the producer price index (PPI) is optimal only under special circumstances. In a calibrated version of the model, PPI targeting is compared against a policy that stabilizes a forecast of the consumer price index. The results depend on model specifics, especially elasticities of substitution and the structure of international asset markets.

Pricing Risks Across Currency Denominations

We document a novel empirical regularity that investors in low interest rate countries earn substantially higher Sharpe ratios on identical carry trade strategies than investors in high interest rate countries. We further document that bilateral exchange rate volatilities are increasing in interest rate differentials between currencies. These observations place new important restrictions on no-arbitrage models of international asset pricing. Our analysis naturally gives rise to a new non-parametric procedure to estimate country-specific stochastic discount factors (SDFs) from exchange rate data. In support of our approach, out-of-sample, the estimated SDFs sort linearly with national output gap fluctuations, and price risks in international equity markets.

Is the World Heading Towards Crisis-Induced Irrational Exuberance in International Assets? Investigating Under Global Financial Stability APT

Is the World Heading Towards Crisis-Induced Irrational Exuberance in International Assets? Investigating Under Global Financial Stability APT

Forecasting Local Inflation with Global Inflation: When Economic Theory Meets the Facts

This paper provides both theoretical insight as well as empirical evidence in support of the view that inflation is largely a global phenomenon. First, we show that inflation across countries incorporates a significant common factor captured by global inflation. Second, we show that in theory a role for global inflation in local inflation dynamics emerges over the business cycle even without common shocks, and under flexible exchange rates and complete international asset markets. Third, we identify a strong correction mechanism that brings local inflation rates back in line with global inflation which explains the relative success of inflation forecasting models based on global inflation (e.g., Ciccarelli and Mojon (2010)). Fourth, we argue that the workhorse New Open Economy Macro (NOEM) model of Martinez-Garcia and Wynne (2010) can be approximated by a finite-order VAR and estimated using Bayesian techniques to forecast domestic inflation incorporating all relevant linkages with the rest of the world. This NOEM-BVAR provides a tractable model of inflation determination that can be tested empirically in forecasting. Finally, we use pseudo-out-of-sample forecasts to assess the NOEM-BVAR at different horizons (1 to 8 quarters ahead) across 17 OECD countries using quarterly data over the period 1980Q1-2014Q4. In general, we find that the NOEM-BVAR model produces a lower root mean squared prediction error (RMSPE) than its competitors --- which include most conventional forecasting models based on domestic factors and also the recent models based on global inflation. In a number of cases, the gains in smaller RMSPEs are statistically significant. The NOEM-BVAR model is also accurate in predicting the direction of change for inflation, and often better than its competitors along this dimension too.

Global Asset Allocation Shifts

We show that global asset reallocations of U.S. fund investors obey a strong factor structure, with two factors accounting for more than 90% of the overall variation. The first factor captures switches between U.S. bonds and equities. The second reflects reallocations from U.S. to international assets. Portfolio allocations respond to U.S. monetary policy, most prominently around FOMC events when institutional investors reallocate from basically all other asset classes to U.S. equities. Reallocations of both retail and institutional investors show return-chasing behavior. Institutional investors tend to reallocate toward riskier, high-yield fixed income segments, consistent with a search for yield.

Volatility Spillover Effects in East Asian Capital Markets: A Case Study to the Real Estate Sectors

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Survey on International Portfolio Investments

At the end of fiscal year 2013, the level of investment held by U.S.- based businesses and individuals in assets abroad was US$ 21.9 trillion, and the position held by foreign-based counterparties in the U.S. $ 26.5 trillion (B.E.A., 2014). With volumes that exceed 30% of the world GDP (World Bank, 2014), these levels of investment must be rationalized by worthy financial reasons. Do these investments tend to concentrate in certain segments of the global economy, and would these segments and areas tend to change through time, and business cycles? In this survey on international portfolio investment several topics are analyzed, including the reasons for investing in foreign markets, the performance of U.S. versus foreign stocks, the risks involved in such investments, hedging techniques to deal with foreign currency risks, and time horizons to consider when investing overseas. The conclusion that follows is that by investing in international assets, using the appropriate instruments with a reasonable hedging strategy, and over the long-term will produce superior returns compared to a purely domestic investment strategy.