How a small open economy's asset are priced by heterogeneous international investors

We study how a small open economy’s assets are prices by heterogeneous international investors. We initially decompose the asset pricing issue into separate studies of its two ingredients: the asset’s ex post return and the investors’ stochastic discount factor. The ex post asset return is examined in a small open economy RBC model featuring adjustment cost in investment. We derive an approximate closed-form solution for the ex post asset return using the Campbell (1994) log-linear technique. The international investors’ stochastic discount factor is taken as given by this small open economy. To examine the international investors’ stochastic discount factor, general equilibrium analysis is called in. We do this by setting up a world economy model. In the world economy model, the production side features a world representative firm which produce the world aggregate output consumed as world aggregate consumption; the consumer side features heterogeneous international investors from N countries in a sense that there are exogenous consumption distribution shocks and the price variation across countries. The shock affects the cross-sectional distribution of consumption goods among international investors but won’t affect the world aggregate level. The market stochastic discount factor hence is derived as a function of the world aggregate consumption growth, the world aggregate price growth and the cross-sectional variances and covariance terms of individual consumption growth and price growth. We then derive the closed-form solutions for asset prices by substituting the two ingredients, the asset’s ex post return from small open economy model and the investors’ stochastic discount factor from a general equilibrium world economy model, into the basic asset pricing formulas. Our model generates a risk premium for a small economy’s asset that tends to be low when the global economy is robust and to soar when global economy experiences a downturn. The main reason behind this is our assumption of heterogeneity across international investors. We also study the capital accumulation and capital loss/gain channels and explore their asset pricing implications. Our major finding is: For a small country that conducts fierce capital accumulation, our model predicts that its risk premium will fluctuate less broadly than one that conducts little capital accumulation.