Heterogeneity and Volatility Puzzles in International Finance

40 Pages Posted: 21 Feb 2009 Last revised: 24 Jan 2011

See all articles by Tao Li

Tao Li

City University of Hong Kong (CityU) - Department of Economics & Finance

Mark Legge Muzere

Suffolk University - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: February 19, 2009

Abstract

We develop an equilibrium model in a two-country, two-good, pure exchange economy in which investors with logarithmic utility functions have heterogeneous beliefs about exogenously given output or endowment processes. We obtain closed-form representations of real exchange rate and of stock prices. We show that heterogeneous beliefs, together with heterogeneous preferences make the volatility of real exchange rates and of stocks exhibit some properties that have been well documented in the empirical literature. These properties include the high volatility of both real exchange rates and stocks compared with that of economic fundamentals, the high correlation of stocks during periods of volatile markets. The model can also generate the clustering of the volatility of foreign exchange rate and stocks if the differences of beliefs are clustering.

Keywords: International Finance, Asset Pricing, Exchange Rate, Heterogeneous Beliefs, Heterogeneous Preferences, Excess Volatility, Correlation of Stock Markets

JEL Classification: D51, D84, G12, G15, F31, F36

Suggested Citation

Li, Tao and Muzere, Mark Legge, Heterogeneity and Volatility Puzzles in International Finance (February 19, 2009). Journal of Financial and Quantitative Analysis (JFQA), Vol. 45, No. 6, pp. 1485-1516, Available at SSRN: https://ssrn.com/abstract=1347210

Tao Li (Contact Author)

City University of Hong Kong (CityU) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

Mark Legge Muzere

Suffolk University - Department of Finance ( email )

8 Ashburton Place-Beacon Hill
Boston, MA 02108-2770
United States

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