International Capital Markets Structure, Preferences and Puzzles: The US-China Case

32 Pages Posted: 13 Feb 2014

See all articles by Guglielmo Maria Caporale

Guglielmo Maria Caporale

Brunel University London - Department of Economics and Finance; London South Bank University; CESifo (Center for Economic Studies and Ifo Institute); German Institute for Economic Research (DIW Berlin)

Michael Donadelli

University of Brescia

Alessia Varani

HEC Montreal

Multiple version iconThere are 2 versions of this paper

Date Written: February 2014

Abstract

A canonical two country-two good model with standard preferences does not address three classic international macroeconomic puzzles as well as two well-known asset pricing puzzles. Specifically, under financial autarky, it does not account for the high real exchange rate (RER) volatility relative to consumption volatility (RER volatility puzzle), the negative RER-consumption differentials correlation (Backus-Smith anomaly), the relatively low cross-country consumption correlation (consumption correlation puzzle), the low risk-free rate (risk-free rate puzzle) and the high equity risk premium (equity premium puzzle) in the data. In this paper, we show that instead a two country-two good model with recursive preferences, international complete markets and correlated long-run innovations can address all five puzzles for a relatively large range of parameter values, specifically in the case of the US and China. Therefore, in contrast to other IBC models, its performance does not rely on any financial market imperfections.

Keywords: Financial autarky, complete markets, long-run risk, anomalies

JEL Classification: F3, F4

Suggested Citation

Caporale, Guglielmo Maria and Donadelli, Michael and Varani, Alessia, International Capital Markets Structure, Preferences and Puzzles: The US-China Case (February 2014). DIW Berlin Discussion Paper No. 1362, Available at SSRN: https://ssrn.com/abstract=2394504 or http://dx.doi.org/10.2139/ssrn.2394504

Guglielmo Maria Caporale (Contact Author)

Brunel University London - Department of Economics and Finance ( email )

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London South Bank University ( email )

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Michael Donadelli

University of Brescia ( email )

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Alessia Varani

HEC Montreal ( email )

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