Puzzles In International Finance

International finance, while grounded in established economic principles, presents several enduring puzzles that challenge conventional wisdom and demand ongoing research. These anomalies often stem from the complexities of cross-border capital flows, exchange rate dynamics, and differing national policies.

One prominent puzzle is the equity home bias. Despite the potential benefits of international diversification, investors predominantly hold domestic assets. Standard portfolio theory suggests that investors should diversify globally to reduce risk and enhance returns. Yet, empirical evidence consistently shows a strong preference for home-country equities. Explanations range from informational asymmetry (investors know more about domestic companies), regulatory barriers, transaction costs, and behavioral biases like familiarity and overconfidence.

The Feldstein-Horioka puzzle highlights the unexpectedly high correlation between national saving and investment rates. In a world of perfect capital mobility, savings should flow freely to countries with the highest investment opportunities, regardless of their domestic saving rates. However, the observed correlation suggests that savings tend to remain within national borders. This challenges the assumption of perfect capital mobility and points to factors such as government policies, exchange rate volatility, and information frictions that hinder cross-border capital flows.

Purchasing Power Parity (PPP), a cornerstone of international economics, states that exchange rates should adjust to equalize the prices of identical goods and services in different countries. However, PPP holds poorly, particularly in the short to medium term. Real exchange rates exhibit persistent deviations from PPP, driven by factors such as non-tradable goods, transportation costs, trade barriers, and sticky prices. While PPP may hold better over very long horizons, its failure to accurately predict exchange rate movements in the short run remains a puzzle.

Another enigma is the forward premium puzzle. Uncovered interest rate parity (UIP) posits that the interest rate differential between two countries should equal the expected change in the exchange rate. However, empirical studies often find the opposite: currencies with higher interest rates tend to appreciate rather than depreciate. This discrepancy suggests that uncovered interest parity fails, possibly due to risk premiums, central bank intervention, or behavioral biases in currency markets.

Finally, the currency risk premium puzzle questions why investors demand a premium for holding assets denominated in foreign currencies. In efficient markets, exchange rate risk should be diversifiable, and thus not warrant a risk premium. However, observed return differentials across currencies suggest that investors do require compensation for exchange rate risk, hinting at imperfections in international capital markets or the presence of systematic risks not fully captured by standard models.

These puzzles underscore the complexities of international finance and highlight the need for continued research into the factors that influence cross-border capital flows, exchange rate determination, and investment decisions in a globalized world. Understanding these puzzles is crucial for policymakers, investors, and academics alike.