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Heterogeneity and Volatility Puzzles in International Finance

Published online by Cambridge University Press:  10 September 2010

Tao Li  and
Mark L. Muzere
Tao Li
Affiliation:
Department of Economics and Finance, City University of Hong Kong, 83 Tat Chee Ave., Kowloon, Hong Kong. [email protected]
Mark L. Muzere
Affiliation:
School of Business, Langston University, PO Box 1500, Langston, OK 73050. [email protected]
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Abstract

We develop an equilibrium model in a 2-country, 2-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 rates 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 rates and stocks if the differences of beliefs are clustering.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 6 , December 2010 , pp. 1485 - 1516
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

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