Book Description

International portfolio diversification is beneficial only if asset returns are not significantly correlated across countries. Therefore, it is essential for investors who want to make an appropriate portfolio selection to understand the nature of asset return correlations. This thesis consists of three essays on international comovements of financial markets. The first essay analyzes the effects of heterogeneous beliefs and learning on international comovements of equity returns and portfolio rebalancing mechanism. This essay develops a continuous-time general equilibrium model in a two-asset and two-good economy with two representative agents, who differ in perceived rates of output growth and accuracy of beliefs. The equilibrium correlations of equity returns across counties and optimal portfolios are expressed in terms of the differences in beliefs. The main findings are: (1) the differences in perceived rates of output growth generate equity home or foreign bias, resulting in lower crosscountry equity return correlations; and (2) the volatilities of optimal portfolios and capital flows increase with the differences in perceived output growth and with the differences in accuracy of beliefs. The second essay studies the effects of trade costs in goods market on international comovements of equity markets and those on equity home bias. This essay develops a continuous-time general equilibrium model in a two-country, two-asset, and two-good setting where international trade of goods is costly. I solve for the optimal portfolios and the equilibrium correlations of cross-country equity returns and analyze how they change depending on the size of trade costs, the coeiffcient of risk aversion, and the elasticity of substitution between domestic and foreign goods. It is found that the cross-country equity return correlations decrease with the size of trade costs. This result is robust to different sizes of trade costs and asymmetry related to potential growth and consumer preferences. It is also found that the size of the trade costs and other parameter values determine whether trade costs would generate equity home bias or foreign bias. The third essay is devoted to an empirical analysis of the effects of financial integration on international comovements of financial markets. The essay provides a characterization of synchronization among 24 countries over the period 1980-2003. A country-pair panel instrumental variables framework is employed to explain time-varying bilateral correlations among national stock returns, by utilizing the dataset on trade costs in Fitzgerald (2008). It is found that finnancial integration driven by reduction of trade costs leads to a higher degree of synchromization across stock markets.