International Financial Integration*

-18-

A. Conceptual Issues

Consider the ex-post real return (on foreign assets or liabilities) in domestic currency and
in US currency. For country i , these are statistically linked by the rate of bilateral real
appreciation vis-à-vis the US

rer

(1 + r.) ≡ (1 + r_it)* —                       (4)

rer ₁
it-1

where r_i^U_t ^S(r_it)is the real return in US dollars (domestic currency) and rer is the bilateral

CPI-based real exchange rate between the domestic currency and the US dollar. Let us
consider the determinants of local currency real returns. Statistically, the aggregate return
on the (asset or liability) position is a weighted sum of the returns on the various
components of the investment position²⁰

rit = ∑ωijrijt                                      (5)

^j

It follows that the aggregate rate of return depends on (i) the returns in each investment
category; and (ii) the proportions invested in the different components. We can model the
former as depending on some common country component, plus an idiosyncratic factor to
the extent that the investment pattern deviates from overall market patterns

j = j *⁺μ_y-t                              (6)

For example, the return on portfolio equity liabilities will equal the return on the domestic
stock market index if foreign investors just ‘hold the market’ but will differ if foreign
investors choose a different portfolio composition.²¹ Similarly, the return on foreign

²⁰ In this setup, we assume time-invariant weights for convenience.

²¹ One could in turn attempt to model the overall domestic return in a given asset category
as a function of national macroeconomic variables. See Barro and Sala-i-Martin (1991) for
an illustration with respect to interest rate determination.

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