Chapter 37 Puzzles in international financial markets

This chapter focuses on two puzzles related to international financial markets. The first puzzle concerns explanations for deviations from uncovered interest parity or, equivalently, excess returns on foreign relative to domestic deposits. The chapter considers various explanations for the puzzle. First, under standard assumptions about rational expectations, ex post excess returns just equal the market's true expected excess returns plus a forecast error that is unpredictable ex ante . The second puzzle is called home bias, the phenomenon that domestic investors hold too little of their portfolios in foreign assets. The chapter considers this puzzle with the two models used to examine the foreign exchange risk premium. Both models suggest that domestic investors hold too little of their wealth in the form of foreign assets. The first type of model, based upon CAPM, implies that domestic investors should hold foreign assets in their portfolio in a fraction that depends upon their degree of risk aversion, among other variables. The second type of model, based upon complete markets, gives predictions about consumption risk-sharing.