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Puzzles in International Financial Markets

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  • Karen K. Lewis
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    Abstract

    This paper presents a survey of two basic puzzles in international finance. The first puzzle is the `predictable excess return puzzle.' The returns on foreign currency deposits relative to domestic currency deposits should be equalized based upon uncovered interest parity. However, not only do researchers find that deviations from uncovered interest parity are predictable ex ante, but their variance exceeds the variance in expected exchange rate changes. In the paper, I describe different explanations of this phenomenon including the view that excess returns are driven by a foreign exchange risk premium, peso problems or learning, and market inefficiencies. While the research to date has been able to better define the `predictable excess return puzzle' and to suggest the most likely directions for future progress, no one explanation has provided a full answer to the puzzle. The second puzzle is the `home bias puzzle.' Empirical evidence shows that domestic residents do not diversify sufficiently into foreign stocks. This evidence is clear whether looking at models based on portfolio holdings or outcomes of consumption realizations across countries. In this paper, I examine several possible explanations including non-traded goods and market inefficiencies, although even after considering these possibilities, the puzzle remains.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4951.

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    Date of creation: Dec 1994
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    Publication status: published as Handbook of International Economics, G. Grossman and K. Rogoff, eds.(North Holland: Amsterdam), 1995.
    Handle: RePEc:nbr:nberwo:4951

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    Cited by:
    1. Helmut Reisen, 1997. "Liberalising Foreign Investments by Pension Funds: Positive and Normative Aspects," OECD Development Centre Working Papers 120, OECD Publishing.
    2. Richard C. Marston, 1994. "Tests of Three Parity Conditions: Distinguishing Risk Premia and Systematic Forecast Errors," NBER Working Papers 4923, National Bureau of Economic Research, Inc.
    3. Luca Benati, 2006. "Affine term structure models for the foreign exchange risk premium," Bank of England working papers 291, Bank of England.
    4. Tai, Chu-Sheng, 2001. "A multivariate GARCH in mean approach to testing uncovered interest parity: evidence from Asia-Pacific foreign exchange markets," The Quarterly Review of Economics and Finance, Elsevier, Elsevier, vol. 41(4), pages 441-460.
    5. Diamandis, Panayiotis F. & Georgoutsos, Dimitris A. & Kouretas, Georgios P., 2008. "Testing the forward rate unbiasedness hypothesis during the 1920s," Journal of International Financial Markets, Institutions and Money, Elsevier, Elsevier, vol. 18(4), pages 358-373, October.
    6. George Furstenberg, 1998. "From Worldwide Capital Mobility to International Financial Integration: A Review Essay," Open Economies Review, Springer, Springer, vol. 9(1), pages 53-84, January.
    7. Marston, Richard C., 1997. "Tests of three parity conditions: Distinguishing risk premia and systematic forecast errors," Journal of International Money and Finance, Elsevier, Elsevier, vol. 16(2), pages 285-303, April.
    8. Vít Pošta, 2012. "Estimation of the Time-Varying Risk Premium in the Czech Foreign Exchange Market," Prague Economic Papers, University of Economics, Prague, University of Economics, Prague, vol. 2012(1), pages 3-17.
    9. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, Elsevier, vol. 3(2), pages 123-192, June.
    10. Tai, Chu-Sheng, 1999. "Time-varying risk premia in foreign exchange and equity markets: evidence from Asia-Pacific countries," Journal of Multinational Financial Management, Elsevier, Elsevier, vol. 9(3-4), pages 291-316, November.
    11. Marianne Nessen, 1997. "Exchange Rate Expectations, the Forward Exchange Rate Bias and Risk Premia in Target Zones," Open Economies Review, Springer, Springer, vol. 8(2), pages 99-136, April.
    12. Tai, Chu-Sheng, 2003. "Can currency risk be a source of risk premium in explaining forward premium puzzle?: Evidence from Asia-Pacific forward exchange markets," Journal of International Financial Markets, Institutions and Money, Elsevier, Elsevier, vol. 13(4), pages 291-311, October.
    13. Nucci, Francesco, 2003. "Cross-currency, cross-maturity forward exchange premiums as predictors of spot rate changes: Theory and evidence," Journal of Banking & Finance, Elsevier, Elsevier, vol. 27(2), pages 183-200, February.
    14. Michael J. Sager & Mark P. Taylor, 2006. "Under the microscope: the structure of the foreign exchange market," International Journal of Finance & Economics, John Wiley & Sons, Ltd., John Wiley & Sons, Ltd., vol. 11(1), pages 81-95.
    15. Fuentes, Cesar A. & Rios, Ronald, 2014. "Non-explicit FOREX intervention: The role of the Central Reserve Bank in a dollarized economy and its effects on expectations from the “peso problem” perspective: The case of Peru," Journal of Business Research, Elsevier, Elsevier, vol. 67(4), pages 558-566.
    16. Alex Maynard & Peter C. B. Phillips, 2001. "Rethinking an old empirical puzzle: econometric evidence on the forward discount anomaly," Journal of Applied Econometrics, John Wiley & Sons, Ltd., John Wiley & Sons, Ltd., vol. 16(6), pages 671-708.
    17. Tai, Chu-Sheng, 2004. "Looking for risk premium and contagion in Asia-Pacific foreign exchange markets," International Review of Financial Analysis, Elsevier, Elsevier, vol. 13(4), pages 381-409.
    18. Vilmunen, Jouko, 1998. "Macroeconomic Effects of Looming Policy Shifts: Non-falsified Expectations and Peso Problems," Research Discussion Papers, Bank of Finland 13/1998, Bank of Finland.
    19. Jan, Yin-Ching & Chou, Peter Shyan-Rong & Hung, Mao-Wei, 2000. "Pacific Basin stock markets and international capital asset pricing," Global Finance Journal, Elsevier, vol. 11(1-2), pages 1-16.

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