A PORTFOLIO THEORY OF INTERNATIONAL SHORT‐TERM CAPITAL MOVEMENTS

THIS THESIS APPLIES the theory of portfolio choice to the study of international shortterm capital movements. The first four chapters present a theoretical analysis of the role of private short-term capital movements in the foreign-exchange market. It is shown that under the normal assumptions of portfolio choice, international interestrate differentials will dictate the allocation of a stock, not a flow, of short-term capital. The time path of adjustment of short-term capital placements to a change in interest incentives is considered. The existence of maturity constraints and other factors cause lagged adjustment, thereby tending to blur the short-term distinctions between the stock-adjustment and flow theories. After a transitional period during which the initial stock of capital was reallocated, no further flows would be induced by the given change in interest differentials as longer portfolio sizes are held constant. Differences in risk, convenience yields, etc. among assets in different national money markets may imply a less than perfectly elastic arbitrage schedule. Thus, even in the absence of exchange controls, the induced reallocation of capital might not be sufficient to force the value of the covered differential to zero. Furthermore, it is to be expected that the arbitrage schedule would be nonlinear and may depend upon the absolute level of interest rates as well as upon interest differentials. Within a context of portfolio growth it was found that interest differentials could be said to determine a flow of capital. If interest differentials determine the percentage of portfolios held abroad, then growth in portfolio size will dictate increased absolute amounts of capital held abroad, even at constant interest differentials. Changes in portfolio size or rates of growth an in interest rates will in general be interrelated. If there is an inverse relationship between changes in portfolio size and interest rates, as one would expect in the short run, then the change in effective portfolio size that would accompany a policy decision to change the level of interest rates would reinforce the impact of the interest-rate change on capital movements. It is also shown that, in equilibrium, the trade balance will determine the allocation of a stock rather than a flow of private short-term capital. While trade imbalances are linked by an accounting identity to accompanying short-term capital flows of equal magnitude and opposite direction, these induced flows will in general generate portfolio disequilibrium. When portfolio balance is restored, a change in the trade balance (or in the terms of trade financing) will have led to a change in the allocation of portfolios, but not to a continuing flow. Because of uncovered arbitrage and speculation, the values of the individual components of the covered interest differential (the foreign and domestic interest rates and the forward and spot exchange rates) as well as this composite value may offset the incentives for short-term capital movements. Recognition of the many factors influencing capital movements raises the question, ignored in the existing empirical literature, of how to "identify" and ascertain the quantitative influence of these factors. In Chapter V existing empirical studies of United States short-term capital