Two essays in International Finance

This thesis consists of two essays on the effects of barriers to international investment on risk premium and investors' portfolio holdings. In the first essay, we develop an international asset pricing model in a two-country framework where there are no restrictions in the domestic market (for example the U.S.). On the other hand, trading in the foreign market (for example an Emerging Market) encounters barriers to portfolio flows and short-sale constraints. The model suggests that freely traded assets (for example those traded in the U.S.) are priced with only a global risk premium, whereas assets that trade under capital flow and short sale restrictions (for example those traded in Emerging Markets) command a global risk premium, a conditional risk premium and a conditional discount. Further, the price of risk of the discount factor is a linear, increasing function of legal limits on holdings of securities that trade in the foreign market. This is the first, arbitrage-free international asset pricing model that studies both short-sale constraints and foreign ownership restrictions. The model uncovers a new pricing factor that provides a measure of economic benefit of relaxing equity ownership restrictions.;We estimate a conditional version of the model for 18 major emerging markets over the period 1989-2007. We find evidence that global and both local risk factors are priced as well as time varying. The relationship between legal limits on holdings of foreign securities and the price of risk of the discount factor is statistically significant, suggesting economic gains from further liberalization of constraints on capital flows.;The second essay evaluates the impact of investability on risk premium in emerging markets. Built upon the theoretical results of the first essay, we decompose the risk premium of non-investable and partially investable portfolios in emerging markets into three components: a global premium, a conditional local premium and a conditional local discount where the discount reflects the benefit of investability on risk premium. Using MGARCH-in-mean technique, we quantify the impact of investability on risk premium for 18 major emerging markets and find that investability contributes to a significant reduction in risk premium of both non-investable and partially investable portfolios. We also document that increase in investability is associated with higher benefit and a larger exposure to the global factor.