Appendix

Famous Puzzles in International Finance

As if international finance is not puzzling enough, there are famous puzzles in international finance as well. Lucky for you! What I mean with puzzle is that empirical observations of the real world aren’t always compatible with the predictions of some theories.

This appendix discusses six well-known puzzles:

The home bias in trade puzzle: People have a strong preference for consumption of their home goods.

The home bias in portfolio puzzle: Home investors prefer to hold home equities.

The Feldstein–Horioka puzzle: Savings and investment are highly correlated at the country level.

The consumption correlation puzzle: Consumption is much less correlated across countries than output.

The exchange rate disconnect puzzle: Short-term volatility in exchange rates doesn’t reflect that of the fundamentals.

The purchasing power parity puzzle: Short-term changes in exchange rates don’t reflect inflation differentials between countries.

You see that the last two puzzles (the exchange rate disconnect and purchasing power parity puzzles) directly related to exchange rates. The other four imply, among other things, exchange rate risk. Now you examine each puzzle:

The Home Bias in Trade Puzzle

Empirical evidence indicates that, within a country trade is much larger than international trade, which suggests a bias for home goods. This observation implies that international goods markets may be much more segmented than one usually assumes. The existence of national borders may contribute to market segmentation, which, among other things, involves trade barriers.

To explain this bias, one needs to assume empirically plausible trade costs, as well as a lower elasticity of substitution across traded goods. The term elasticity of substitution refers to the ease with which domestic goods (nontraded) can be substituted with traded goods. In terms of international trade, border costs imply trade barriers such as tariffs and nontariff barriers (quantitative trade restrictions such as quotas, health and environmental regulations, and customs-related paperwork), transportation costs, and exchange rate risk. Some models suggest that these border costs don’t have to be too large to generate the observed bias for home goods. As long as interaction takes place between border costs and the elasticity of substitution between home and foreign goods, a bias for home goods is in play. Additionally, if a bias for home goods does exist, such as having a preference for the “Made in America” label, it works like any other trade cost.

The Home Bias in Equity Puzzle

Most economic models assume that investors take advantage of risk sharing and potential gains in returns provided by international capital markets. But empirical studies show that investors don’t optimally diversify internationally, and they favor their home country’s equity to the extent of holding almost all their wealth in domestic assets. The question is why domestic investors don’t make use of potential gains from foreign investment opportunities. This question is especially puzzling when you consider the rapidly growing international capital markets.

Consider an example that demonstrates why having portfolios consisting of mostly domestic equities is puzzling. Remember the home bias in trade puzzle, which implies a much larger share of country trade in consumption. You know about various trade costs associated with goods trade. But what about international trade in equities? Suppose that every country has equities issued by firms in the traded and nontraded goods sectors. In theory, trading equities between countries should happen without frictions. Now suppose that there’s no money in the world, and when you hold equities, you’re paid in goods that you consume. Therefore, if you hold an equity (related to firms producing traded or nontraded goods at home or abroad), you’re paid in some particular good. In terms of domestic equities, under normal circumstances, the distinction between traded and nontraded goods doesn’t matter to you. If you receive your dividends in terms of haircut coupons, you can redeem them in your country. But if you’re holding foreign equities, you need to hold the equity associated with the traded good. If you get paid in nontraded goods like haircuts, getting haircuts in a foreign country will be prohibitively expensive (with that airline ticket and all).

Therefore, depending on the share of nontraded goods in home and foreign output, one may expect some representation of foreign equity in domestic portfolios. But the observed domestic equity shares of 80 to 90 percent aren’t consistent with optimal portfolio diversification.

Some explanations of this puzzle are based on trade costs, which also include market inefficiencies such as asymmetric information and legal restrictions as a type of trade cost. But these explanations may apply more to developing countries that implement restrictions on capital flows and foreign ownership of domestic assets than to developed countries. Therefore, the question is why there is a bias for home equity even in developed countries. Given the fact that international equity transactions aren’t significantly restricted in developed countries, one would not expect a strong home bias in equity holdings of developed countries.

But some studies suggest that potential benefits from investing in foreign equities must be compared to the transaction costs of acquiring these equities. Although transactions costs may be small with fully integrated capital markets, they must be compared with the potential gains from diversification. Another explanation is that the market is inefficient and investors don’t recognize the potential gains from including foreign equity in their portfolio. Additionally, some studies suggest that domestic investors are overly optimistic about the returns on domestic equities.

The Feldstein–Horioka Puzzle

In the absence of transaction costs and other frictions, savings and investment shouldn’t correlate at the country level for a small country. This prediction implies that, assuming no restrictions between countries, capital should flow from lower-return regions to higher-return regions. This idea makes sense, if you can think of yourself as an investor: You want to invest in a country with the highest return (assuming the same risk and maturity of the instrument).

The overwhelming empirical evidence indicates that savings and investments are highly correlated at the country level. But if capital flows freely between countries, a country’s investment shouldn’t correlate with its savings. Domestic agents can get funds anywhere in the world and invest in the home country. The most important empirical evidence is obtained in studies that investigate capital flows within the OECD (Organization of Economic Cooperation and Development) countries that consist of mostly developed countries, with minimum restrictions on capital flows. What makes this puzzle even more interesting is that it isn’t a short-term phenomenon. The data used in most empirical studies regarding this puzzle involve decade averages.

So why do domestic savings overwhelmingly finance domestic investment? As in the case of other puzzles, among the usual explanations are market imperfections. Costly information about international risk (including exchange rate risk), as well as restrictions in capital flows, may force domestic savings and investment to correlate. As discussed previously, restrictions on capital flows may seem small, but their interaction with information costs may be enough to reject the predictions that savings and investment shouldn’t be highly correlated.

The Consumption Correlation Puzzle

In a complete market world in which agents are able to exchange every good with other agents without transaction costs, you may expect that domestic consumption growth doesn’t depend too much on country-specific output. Therefore, the theory suggests that consumption should be much more correlated across countries than output. But empirical studies indicate that consumption is much less correlated across countries than output. In other words, there isn’t much international risk sharing in terms of consumption. In a way, in the presence of all three previous puzzles (home bias in trade and equity, as well as the Feldstein–Horioka puzzles), it’s not surprising that international consumption correlations are low.

Explanations of the consumption correlation puzzles are related to explanations associated with the previous puzzles, which emphasize a variety of market imperfections and, therefore, transaction costs. For example, empirical evidence indicates that financial markets more effectively promote risk sharing within a country than between countries. Therefore, financial markets are able to smooth consumption among the U.S. states at a much higher degree than among developed countries. In this context, the term smoothing refers to counterbalancing the increase or decrease in household consumption by exporting or importing consumption goods, respectively.

The existence of nontraded goods can also break the link between prices and quantities and make it harder for trade to smooth household consumption. Suppose that households consume goods that cannot be traded — for example, services like haircuts. If a positive technology shock increases the supply of services, households cannot smooth their consumption of services by exporting haircuts to other countries.

The Exchange Rate Disconnect Puzzle

This puzzle refers to the weak short-run relationship between the exchange rate and its macroeconomic fundamentals. In other words, underlying fundamentals such as interest rates, inflation rates, and output don’t explain the short-term volatility in exchange rates. For example, short-term forecasts of macroeconomic exchange rate models are little better than forecasts of random walk models. A short-term exchange rate determination according to the random walk model implies that tomorrow’s exchange rate equals yesterday’s exchange rate.

Therefore, you need to put into perspective the models or concepts about exchange rate determination from Chapters 5 through 9 and modify your knowledge. Models of exchange rate determination are good approximations for the long-run relationship between exchange rates and macroeconomic fundamentals. The exchange rate disconnect puzzle implies that macroeconomic fundamentals don’t explain short-term variations in exchange rates.

The exchange rate disconnect puzzle and the purchasing power puzzle are considered pricing puzzles. Therefore, explanations of the exchange rate–related puzzles make use of comparing exchange rates to asset prices. As in the case of exchange rates, asset prices such as stock market indices are highly volatile, and the changes in them don’t strongly correspond to changes in fundamentals. Similar to exchange rates, random walk models are reasonably consistent with changes in stock prices. In the case of asset prices in general, the assumption is that news affects asset prices. Still, given the relevance of exchange rates as relative prices and their effect on a large number of transactions, it’s surprising that disconnect exists between short-term changes in exchange rates and underlying macroeconomic fundamentals.

The exchange rate disconnect puzzle has various manifestations. Predictable excess returns are one of them. According to interest rate parity (IRP), the differences in home and foreign interest rates should be equalized by changes in the exchange rate. But studies find two characteristics of short-run exchange rates that aren’t consistent with the IRP:

Not only do short-term exchange rates deviate from the IRP, but these deviations are predictable.

The variance of these predictable returns is greater than the variance of the expected change in the exchange rate.

Predictable excess returns have two explanations:

Market forecasts are irrational: This irrationality may arise from the presence of heterogeneous traders in the market. Heterogeneity among traders means that there are different types of traders such as fundamentalists (they keep an eye on macroeconomic conditions that affect exchange rates), chartists (they use charts or graphs about past changes in exchange rates to forecasts future changes), and noise traders (they follow trends in exchange rates and overreact to good or bad news; also called irrational). (Some studies consider all traders who don’t make investment decisions based on fundamentals (chartists and noise traders) as noise traders or irrational.) Studies show that irrational traders can affect prices; because they face a higher risk, they can earn higher returns than rational traders.

Differences may arise in the distribution of perceived and measured economic disturbances (perceived by traders and measured by researchers): In this explanation, market participants are rational. But systematic forecast errors reflect the difference between what traders observe as they experience the situation and how researchers make sense of it ex post (or after the fact). Still, this approach doesn’t explain the high variation in excess returns.

Peso problem effect: A peso problem refers to the situation in which market participants’ expectations about a future policy change don’t materialize within the sample period. In the early 1970s, interest rates on Mexican peso were substantially higher than those in the U.S. This was happening despite the fact that the Mexican peso had been pegged for almost a decade. Nominal interest rates on the Peso were higher than in the United States and reflected higher inflation rates in Mexico along with the probability of a large devaluation of the peso. A couple years passed before, in the late 1970s, the Mexican peso was devalued.

This situation isn’t consistent with standard assumptions about forecast errors. Forecast errors should have a mean of zero and shouldn’t correlate with current information. But if market participants expect a future discrete change in policy or fundamentals, then rational forecast errors can be correlated with current information and may have a nonzero mean in finite samples.

The Purchasing Power Puzzle

The purchasing power puzzle is an example of the exchange rate disconnect puzzle. As Chapter 9 shows, according to the purchasing power parity (PPP), changes in exchange rates should reflect inflation differentials between countries. However, empirical studies show that short-term deviations from the PPP are quite persistent.

Here I explain the purchasing power puzzle by using the real exchange rate.

The real exchange rate includes the ratio of two countries’ price levels and the nominal exchange rate (see Chapter 2). It implies:

Here, RER, PE, and PUS indicate the real exchange rate, the price of the Euro-zone’s consumption basket, and the price of the U.S. consumption basket, respectively. In this equation, if you multiply the dollar–euro exchange rate by the price of the European consumption basket (denominated in euro), euros cancel, and you have the price of the European consumption basket in dollars. Therefore, the real exchange rate compares the price of a country’s consumption basket to that of another country in a common currency.

You can relate the real exchange rate to the purchasing power puzzle in the following way. The previous equation of the real exchange rate includes the nominal exchange rate, and you know that the short-run changes in the nominal exchange rate don’t reflect the changes in macroeconomic fundamentals (in this case, the price levels of two countries). Because the volatility in the nominal exchange rate is much more than the volatility in domestic and foreign price levels, then the volatility in the real exchange rate is high as well.

The question is, what can generate large and persistent international price differentials? Here are some possible answers:

The exchange rate pass-through implies the effect of changes in the exchange rate on import prices in home currency. You may expect that, eventually, the changes in consumer prices will reflect the changes in import prices. But even though the exchange rate pass-through takes place, consumer prices adjust sluggishly to changes in import prices.

Another popular explanation of persistent international price differentials is based on imperfect competition. As opposed to perfect competition where firms are price takers (they take the market price of their products), in imperfect competition producers have the opportunity to price their products as well as price discriminate in home and foreign markets. Then the argument goes that if most traded goods are produced under imperfect competition, price differentials become persistent. But although the production of some traded goods under the conditions of imperfect competition is reasonable (such as cars), it doesn’t apply to other traded goods (such as apparel).

A variation of the previous argument is used for wholesalers, which doesn’t require the firms to be monopolies. Clearly, consumers can’t profitably arbitrage price differences in traded goods, but wholesalers should be able to. Apparently, something is preventing wholesalers from engaging in international price arbitrage at the wholesale level. Perhaps wholesalers don’t have control over firms’ legal rights, such as marketing licenses that enable firms to price discriminate, in other words, to charge different prices in different countries.

Market Imperfection Explanations for Exchange Rate Puzzles

This section focuses on explanations of the famous puzzles that relate to market imperfections. It shows that some of the basic assumptions about markets may not hold in foreign exchange markets.

In most economic models, market behavior has the following characteristics:

Trading costs and other frictions are small so that they don’t affect the market outcome (prices and quantities).

Whatever the nature of the shock is, market equilibrium prevails.

Market participants behave rationally.

These assumptions may reasonably explain goods markets, but they seem to not hold completely in financial markets. Because currency markets behave similarly to asset markets, the lack of efficiency in currency markets may partially explain the famous puzzles in international macroeconomics and finance. Even though usually one assumes that competitive markets determine exchange rates in floating exchange rate regimes, foreign exchange markets may be less than efficient.

As in the case of asset markets, the following assumptions of the efficient markets hypothesis may be systematically violated in foreign exchange markets as well:

Trading costs can be quite large. The most important of these costs is the information cost associated with acquiring and analyzing information to assess the risk and return of an asset or a currency.

• Fragile expectations make assessing risk and uncertainty particularly difficult.

• Information asymmetry persists. Sharing valuable information may not come with many incentives.

• Information asymmetry can be a factor for not making use of arbitrage opportunities that are important for market efficiency.

A basic difference exists between commodity and asset markets. To appreciate this difference, consider expectations in any market. A market has a feedback system in terms of expectations. As a market participant, you consider past market behavior to form your expectations and, then your decision determines the current market behavior.

An expectations-based market system can have a positive or negative feedback system. Supply-driven commodity markets have a negative feedback system. When producers expect future prices to be high, they increase production, which results in lower prices of their product. When firms expect future prices to be lower, they decrease production and have to deal with higher prices of their product. In this case, prices quickly converge to their equilibrium value.

Financial markets are demand driven, and there is positive (self-confirming) feedback. When there’s an expectation of higher prices of an asset, market participants start buying it, increasing the demand for the asset and, thereby, its price. When market participants expect lower prices, they decrease their demand, and the price of the asset falls. Therefore, positive feedback in asset markets is capable of producing large fluctuations in the actual price of assets.

Herding behavior among asset market participants such as traders, fund managers, and analysts is an important deviation from market efficiency and implies information costs. It means that if you and I are the two traders in the foreign exchange market, I just watch you and sell or buy the currencies that you sell and buy. Why do I mimic your behavior? I must face a prohibitively high information cost, so instead of gathering information to base my trade on, I simply watch you and trade as you do. Information costs generate significant and sometimes persistent deviations from market equilibrium and create path-dependent prices.