The Volatility of International Capital Flows and Foreign Assets

Joint with Adrien Verdelhan

March 2017

This paper presents a two-good, two-country real model that replicates the basic stylized facts on equity excess returns and real interest rates. In the model, markets are incomplete. In each country, workers cannot participate in financial markets whereas investors trade domestic and foreign stocks, as well as an international bond. The investors’ asset positions are subject to a borrowing constraint, along with a short-selling constraint on equity. Foreign and domestic agents differ in their elasticity of inter temporal substitution and in their risk-aversion. A time-varying probability of a global disaster implies time-varying risk premia in asset markets, and therefore large and time-varying expected valuation effects on international asset positions. The model highlights the role of market incompleteness and heterogeneity across countries in accounting for the volatility of equity and debt international capital flows.