Essays on International Asset Allocation and Pricing

Thesis (Ph.D.)--University of Washington, 2016-06

My dissertation studies financial asset allocation and pricing in open economy framework. In the first chapter, I investigate why countries with more flexible exchange rate policies tend to hold more domestic bonds in their portfolios. First, I show that fewer domestic bond holdings under a pegged regime than under a floating regime is mainly because international bond position cannot hedge against real shocks when the exchange rate is pegged. Therefore, exchange rate regimes are non-neutral for asset holdings through changing the hedging characteristics of nominal assets. Second, I show that, under a floating regime, more domestic bond holdings by countries with more volatile nominal exchange rates can be explained by more volatile real shocks. I develop a two country DSGE model with endogeneous portfolio choice in which nominal bonds are traded internationally and exchange rate regimes are characterized by interest rate rules. In the second chapter, I investigate how international equity mutual funds allocate their portfolios across countries and what factors determine their asset allocation decisions using micro-level data on mutual funds. I find that equity fund managers are actively engaged in a rebalancing strategy to manage their global portfolios and the motive behind this action is more related to equity market risk rather than to currency risk. I also show that the fund managers' degree of rebalancing is larger in times of higher global uncertainty and in equity markets that exhibit a stronger correlation with the global market, implying that global risk has asymmetric effect on international asset allocation. In the third chapter, I expand a closed economy macro-finance model with a recursive preference into an open economy model, to better understand the determinants and co-movement of term premia across countries. I find that term premia are lower in an open economy setup than in a closed economy setup due to increased risk sharing across countries. In addition, I show that both underlying shocks and stochastic volatility shocks have to be highly correlated across countries to explain the cross-country co-movement of term premia, whereas the co movement of yield spreads is more driven by correlated policy expectations rather than by correlated term premia. I build a two-country DSGE model with the Epstein-Zin preference and stochastic volatility shocks. The third chapter, as well as the second chapter, emphasizes the role of global common risk in an open economy.