Essays in financial economics

This dissertation consists of two essays that deal with related issues in international finance. These issues are capital controls and how differences in preferences and beliefs across countries are reflected in asset prices.; The first essay studies the effects of a particular type of illiquidity motivated by capital controls that are popular from time to time in developing countries. We find that a country's policy of limiting the rate of capital withdrawal restricts foreign investors' willingness to invest there initially. This result is derived in an intertemporal model of the optimal portfolio choice of a foreign investor. The model is solved in closed form up to the determination of one constant. An investor's optimal policy features a singular control with net investment in the country when at a free boundary and net disinvestment at the maximum rate at all other times. We show that increasing the allowed rate of capital withdrawal leads to increased investors' willingness to invest in a country. The model is consistent with the empirical regularity of home bias in equity, which is the tendency of investors to invest more domestically (at home) than would seem to be implied by optimal.; The second essay (co-authored with Tao Li) seeks to provide an explanation of several volatility regularities in international financial markets, which are “puzzling” since standard models in economics have difficulty in explaining them. We develop an equilibrium model in a two-country pure exchange economy in which investors with logarithmic utility functions have heterogeneous beliefs about exogenously given dividend (endowment) processes. We obtain closed-form representations of the real exchange rate and of the stock prices, and we show that the heterogeneity of investors' beliefs has a significant impact on the equilibrium of the economy. In particular, heterogeneous beliefs together with heterogeneous preferences make the volatility of real exchange rates and the volatility of stock prices exhibit some properties which have been documented in the empirical literature. Those properties include the high volatility of short-term movements of real exchange rates, clustering of the volatility of real exchange rates, transmission of the volatility of stock prices from one international equity market to another, clustering of the volatility of stock prices, and the observed volatile stock prices compared to underlying dividends, with transmission of the volatility of stock prices across international equity markets amplifying this effect.