Essays on international asset pricing in general equilibrium

A continuous-time general equilibrium model for multi-good production-exchange open economies with flexible exchange rates is constructed for pricing international assets by integrating production decision with portfolio choices. The equilibrium prices and exchange rates are endogenously determined in terms of macroeconomic variables and technological uncertainty. The equilibrium pricing functions exhibit fundamental risks, namely productivity, technology and market risks. The exchange risk alters the composition of these risks and is shown to be their derivative. Consumer-investors maximize life time utility by choosing optimal consumption rates and by allocating wealth among stochastic constant-returns-to-scale technologies and assets available in each country. Technology shocks are imparted by exogenous state variables following Itô processes. Equilibrium and market clearing conditions are specified and the model is closed with the assumption of Rational Expectations. Itô's Lemma give the dynamics of exchange rate and fundamental valuation equation.

A simplified version of the model is employed to study the determinants of net foreign investment. The industry shares and asset demand functions obtained from the optimization problem of home and foreign investors are used to derive net foreign investment. Comparative-static results show that net foreign investment is sensitive to rate of return on foreign technology and its variance, the exchange rate, consumption expenditure elasticity of imports and the level of imports.

In another variant of the model the fundamental valuation equation is used to price the foreign exchange forward, futures and options. The valuation formulas emphasize the role of intertemporal marginal rate of substitution across currencies. The forward and futures exchange rates are not unbiased predictors of the future spot exchange rate because of the uncertainty of the marginal utility of future consumption and the exchange rate. A forward currency contract involves speculation on the future spot exchange rate whereas a futures currency contract involves speculation on the interest rate as well as the future spot exchange rate. Valuation of currency options is similar to the forward contracts.