International Capital Flows, Returns and World Financial Integration

Abstract

International capital flows have increased dramatically since the 1980s, with much of the increase being due to trade in equity and debt markets. Such developments are often attributed to the increased integration of world financial markets. We present a model that allows us to examine how greater integration in world financial markets affects the behavior of international capital flows and financial returns. Our model predicts that international capital flows are large (in absolute value) and very volatile during the early stages of financial integration when international asset trading is concentrated in bonds. As integration progresses and households gain access to world equity markets, the size and volatility of international bond flows fall dramatically but continue to exceed the size and volatility of international equity flows. This is the natural outcome of greater risk sharing facilitated by increased integration. We find that the equilibrium flows in bonds and stocks are larger than their empirical counterparts, and are largely driven by variations in equity risk premia. The paper also makes a methodological contribution to the literature on dynamic general equilibrium asset-pricing. We implement a new technique for solving a dynamic general equilibrium model with production, portfolio choice and incomplete markets.

International portfolios: A comparison of solution methods

“…The DS method provides readily applicable solution formulas for the zero-order and first-order parts of an approximation to portfolio holdings, and has, because of its user-friendliness become widely used in recent contributions in macroeconomics. Other noteworthy contributions to solving portfolios with local approximation methods are Samuelson (1970), Judd and Guu (2001), Tille and van Wincoop (2007), and Evans and Hnatkovska (2005)). 9 The DS perturbation solution method is straightforward to implement and in simple settings it is possible to obtain an analytic characterization of the approximate portfolio solution, which can be helpful for building intuition for the mechanisms at play.…”

“…The DS solution method delivers an equivalent solution (for zero-and first-order portfolio holdings) as the iterative method by Tille and van Wincoop (2007). Finally, the DS method is quite different from Evans and Hnatkovska (2005), who combine perturbation methods with continuous-time approximations.…”

The Impact of Financial Openness on the Size of Utility-enhancing Government

“…Thus, the measures of financial openness used in this paper can conceal a high degree of volatility in terms of capital flows. Recent research has shown that changes in cross-border holdings and capital flows move together (Evans and Hnatkovska, 2012). This result can also be checked in our sample by comparing the domestic portfolio materialized in foreign capital as a share of domestic wealth, FO1, with the corresponding underlying flow for domestic capital.…”

“…16 Additionally, this research does not investigate how volatility in international capital flows affects the real economy. The volatility of flows seems to have fallen substantially with the huge increase in international capital flows, presumably because of the increased cross-border integration of financial markets (Evans and Hnatkovska, 2012), although volatility is an important factor associated with long-term growth, as shown by recent evidence (Mody and Murshid, 2011). This paper proceeds as follows.…”

Development threshold, capital flows, and financial turbulence

“…3 See Edwards (2005Edwards ( , 2007 and Edwards and Rigobon (2009), Evans and Hnatkovska (2005), Ito (2006, 2008), Prasad, Rajan, et al (2007), Honig (2008), and Neumann, Penl, and Tanku (2009). The figure provides a scatter plot of the relationship between capital flows and the level of income for each country.…”