Investors' Behavior and Equilibrium Relationships in International Financial Markets Under Uncertainty: a Continuous-Time Approach (Portfolio, Currency Substitution, Asset Pricing Models, Interest Rate Parity, Exchange Rate Determination).

Abstract

This thesis embodies a two-country investment-consumption model under a flexible exchange rate regime stochastic investment-consumption opportunity set. Each country has a competitive banking industry and consumption goods must be paid for with domestic or foreign dem and deposits. The Optimal Stochastic Control technique is employed to solve for the optimal consumption-investment decisions of individuals. Assuming complete as well as incomplete capital markets, the effects of exchange risk, currency substitution, and deviations from PPP on investors' portfolio decisions are discussed. A model that completely specifies the dem and and the supply of forward exchange contracts is developed, and the most complete set of conditions under which the forward rates will be biased estimates of the future spot rates are presented. The thesis also present a model of exchange rate determination under currency substitution and rational expectations. A consumption based CAPM is derived which demonstrates that in a monetary economy the riskiness of a security depends on its covariances with changes in supplies of currencies and aggregate production of consumption goods. The effects of barriers to the international movement of capital are also discussed. It is shown that because of taxes investors will not diversify internationally and that a Security Market B and will depict the risk-return tradeoff in international financial markets. Assuming that asset returns follow nonstationary processes and that investors use past returns to estimate the parameters of the processes, the Optimal Nonlinear Filtering technique is employed to demonstrate that because of estimation risk and estimation error, domestic investors would underinvest in foreign securities and would require a premium for investing in them. Finally, the effects of international integration of financial markets on the riskless interest rate and the market price of risk are discussed. It is shown that the postintegration rate is equal to a weighted average of the preintegration rates plus two factors that account for changes in the market price of risk and the diversification benefits received by investors.