THREE ESSAYS IN INTERNATIONAL ... - Stanford University

[Pages:132]THREE ESSAYS IN INTERNATIONAL FINANCE

A DISSERTATION SUBMITTED TO THE DEPARTMENT OF ECONOMICS

AND THE COMMITTEE ON GRADUATE STUDIES OF STANFORD UNIVERSITY

IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF

DOCTOR OF PHILOSOPHY

Brian Byongju Lee August 2011

? 2011 by Byong-Ju Lee. All Rights Reserved. Re-distributed by Stanford University under license with the author. This dissertation is online at:

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I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy.

Ronald McKinnon, Primary Adviser I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy.

Kyle Bagwell I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy.

Han Hong

Approved for the Stanford University Committee on Graduate Studies. Patricia J. Gumport, Vice Provost Graduate Education

This signature page was generated electronically upon submission of this dissertation in electronic format. An original signed hard copy of the signature page is on file in University Archives.

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Abstract

This thesis consists of three essays on international finance. The first essay is "Exchange rates and Fundamentals". A new open interest rate parity condition that takes account of economic fundamentals is developed from stochastic discount factors (SDFs) of two countries. Through this parity condition, business cycles or fundamentals are linked to exchange rates. Key empirical findings from this parity condition are as follows. First, this model beats the random walk hypothesis: economic fundamentals explain exchange rate movements for high interest rate currencies. Exchange rates of low interest rate currencies act like a random walk because they are less correlated with fundamentals owing to their low risk. For example, U.S. business cycles explain the direction of changes in exchange rates against the dollar. The same thing is true for Japan. Second, this model resolves the forward premium puzzle: the forward premium puzzle is not a general characteristic as regarded in previous studies. It happens when the risk awareness of investors is low, during economic expansions and for low risk currencies. The second essay is "Carry Trade and Global Financial Instability". Carry trade, an opportunistic investment strategy that takes advantage of interest rate differential across countries, is identified the cause of the large-scale depreciations of peripheral currencies in the later half of 2008. A simultaneous equations model, which is derived from a conceptual partial equilibrium model for a local foreign exchange market, is estimated from a cross-sectional sample. The results suggest that the larger appreciation of the yen than the dollar was brought about by a lack of the local supply of the yen rather than a more severe crunch of yen credits. The third essay is "The Economic Origin of Letters of Credit". This essay discusses

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the economic origin of letters of credit, an instrument widely used in international trade. A game theoretical analysis shows that letters of credit improve efficiency in trade settlements, increasing returns in trade. A few notable facts on letters of credit are discussed. First, the new institution is adopted by merchant banks to maximize their profits and in the process, an improvement in efficiency of international transactions is obtained. Second, the organization established by the legacy institution, bills of exchange, played a critical role in adopting the new institution. Third, the legal enforcement is not essential in this economic institution. Finally, two drivers are identified that improve efficiency of transactions: concentration and projection.

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Acknowledgements

I have been interested in economics since I was in my alma mater, KAIST in Korea. Although the school did not offer an economics program, I took a few economics courses during my study there. My advisor then, Prof. Yu Pyung-il and Kim JaeCheol encouraged me and my first advisor, Prof. Chae Kyung-Chol was always kind and patient to support me.

After spending seven years in career, I came to Stanford, initially for the master program in statistics. I met my advisor Prof. McKinnon in his international finance class. Since then, he guided and supported through Ph.D admission to completion of the Ph.D. program. He led and challenged me in the academic area and I am very grateful for his generous RAships through the program. I am enormously in indebted to him.

Throughout the program, helps from Prof. Kyle Bagwell, Prof. Han Hong, Prof. Stefan Nagel, Prof. Darrell Duffie and Prof. Mordecai Kurz were pivotal. They extended their kindness beyond my surprise.

I appreciate friendship with Nadeem, David, Paul and Ray at Stanford.

My wife, Kunyoung Park, has been a great advisor and a talented secretary to me and a caring mother to my two sons, kindhearted Jaeryoung and confident Seryoung. My family is expecting a precious boy in December. My mother-in-law Mrs. K.I. Kim and father-in-law Mr. J.D. Park have been always with my family whenever we

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needed helps. I thank my parents for encouragements and supports despite all the hardships they had. Lastly, my mother, Hong Sung-Pyo is the greatest leader in my life.

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Contents

Abstract

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Acknowledgements

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1 Exchange rates and Fundamentals

1

1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1.2 The Fundamental Open Interest Parity and its Implications . . . . . 12

1.2.1 Stochastic Discount Factors . . . . . . . . . . . . . . . . . . 12

1.2.2 The Fundamental Open Interest Parity . . . . . . . . . . . . 14

1.2.3 The Forward Premium Puzzle . . . . . . . . . . . . . . . . . 18

1.3 Estimations of the fundamental open parity condition . . . . . . . . 19

1.3.1 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

1.3.2 Evidences against the Random Walk Hypothesis . . . . . . . 24

1.3.3 The Fundamental Open Interest Parity with Factors . . . . . 34

1.4 Discussions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

1.4.1 Carry Trade Returns . . . . . . . . . . . . . . . . . . . . . . 41

1.4.2 The Forward Premium Puzzle . . . . . . . . . . . . . . . . . 43

1.5 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

2 Carry Trade and Global Financial Instability

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2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

2.2 Conceptual Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

2.3 Empirical Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

2.4 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

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