THREE ESSAYS ON THE MICROECONOMICS OF INTERNATIONAL FINANCE (FOREIGN EXCHANGE, FORWARD MARKETS, ASSET PRICING, OPTION, PORTFOLIO)

The three essays involve the spot, forward and option markets for foreign exchange rates respectively. The first essay develops a very general, although partial equilibrium microeconomic model with multiple assets, goods, currencies, and tax rates in stochastic continuous time, and uses it to test for these possible sources of heterogeneity in the international pricing of risky capital assets with inflation and exchange rate risks. Applying various econometric procedures including MLE with nonnormal disturbances, it is found that national constraints on investment opportunity sets rather than national differences in attitudes toward risk or in consumption preferences account for heterogeneity in asset pricing. The second essay examines the factors underlying variations in risk premia and in market forecast errors in forward exchange markets. Accounting for strong non-normality in the data, it is shown that we cannot be unequivocal about whether variations are stronger in risk premia or in market forecast errors. Then, optimal portfolios of currency forward contracts, formed under realistic market conditions, are found to generate favorable average out-of-sample risk-return profiles over the entire post Bretton Woods period. Finally, the property of high signal-to-noise ratio in this optimal portfolio returns series is utilized to demonstrate that variations in both risk premia and market forecast errors are driven by fluctuations in such macroeconomic variables as differential production, interest and inflation rates, and money supplies than financial market indices. The third essay tests, more rigorously and using far more extensive data than in previous research, for departures from normality of exchange rate probability distributions. The results of these tests confirm that daily and weekly exchange market returns tend to be strongly nonnormal. The stability-under-addition property of the underlying distribution is upheld under chronological but not random ordering. No strong and unambiguous day-of-the-week effects are found, except for some evidence of a Wednesday effect. Next, foreign currency option pricing formulae for the normal, Pareto and beta probability models are developed in discrete time and tested with transactions data. The results are mixed: under certain circumstances the Pareto model outperforms the normal and vice versa, but both outperform the beta