Essays on International Finance

This dissertation studies two issues on international finance: predictability of foreign exchange market and distributional approach to economic distress from small from small economic disturbances to catastrophic crises. Chapter 1, which is co-authored with Aaron Tornell and Zhipeng Liao, investigates whether social learning can help to account for the existence of predictability in the foreign exchange market. We present an heterogeneous-agent asset pricing model where fundamental shocks lead to amplification cycles (bubbles), and the principle of contrarian opinion holds: in equilibrium, less-informed speculators become overly optimistic (pessimistic) when prices diverge enough from fundamentals and the bubble is likely to burst. Informed forward-looking speculators find it optimal to ride the bubble until a time when they switch the sign of their positions. At this switching time, the bubble continues to grow as less-informed speculators become more optimistic (pessimistic). Based on the implications of the model, we propose a forecasting strategy that estimates structural breaks in the bivariate process followed by exchange rates and speculators' positions. Across the six major currencies, our forecasts outperform the random walk over forecasting horizons from 1 months to 12 months. Chapter 2, which is co-authored with Aaron Tornell and KeyYong Park, looks at the size distribution of economic distress events over the recent period of globalization (1970 - 2014) and the long historical period (1830 - 2013). We find that there exists a remarkable relation between the magnitude of economic distress events and the frequency with which they occur. We document that there is a threshold below which the size of ED events follows an exponential distribution while a Pareto distribution (a power-law) applies for ED events larger than the threshold. To explain the empirical results, we present a wildfire model in which the dynamics of an individual ED event is determined by the interaction of two opposing forces: (i) the natural stochastic growth of the ED, which is proportional to the size of the damage that has already occurred; and (ii) a policy that attempts to extinguish the economic distress. We then derive the steady-state cross-sectional distribution of the final size of the ED events. Chapter 3 analyzes the forward premium puzzle both on developed and emerging economies. The forward premium puzzle tends to exist on developed economies, but not on emerging economies. From the theoretical model of Gourinchas and Tornell (2004), the forward premium puzzle can be explained when investors have a biased belief which overestimates transitory shocks to persistent shocks about the interest rate process. I decompose interest rate differential process with transient and persistent components by using the state space model. Both developed and emerging countries have persistent interest rate differential processes, but developed countries tend to have relatively larger shocks that connect to the persistent component