International Financial Integration*



-30-

Finally, we turn the relation between domestic- and foreign-currency ex-post real returns
and exchange rates in Table 7. In column (1), we report the correlations between
domestic- and foreign-currency real returns on aggregate foreign assets. The mean
correlation is actually negative: an increase in the local-currency real return is typically
associated with a fall in the dollar real return, demonstrating the importance of exchange
rate shifts in de-linking real returns across countries. As shown in column (2), domestic
real returns are lower during periods of real appreciation. As noted earlier, this could be
due to several mechanisms but is consistent with the returns on at least some foreign assets
being driven by external factors. Column (3) shows a very strong positive correlation
between dollar real returns on foreign assets and the real exchange rate, suggesting that at
least some of the returns on foreign assets are driven by domestic factors.

The correlation patterns on the foreign liability side are shown in columns (4)-(6). As
shown in column (4), there is essentially no correlation between domestic and dollar real
returns on foreign liabilities. The negative (positive) correlation between domestic (dollar)
returns and the real exchange rate is also very high, in line with the pattern on the foreign
asset side, and is consistent with a role for both foreign and domestic factors in
determining returns on foreign liabilities.

In summary, this section has provided an exploratory analysis of rates of return and yields
for foreign assets and liabilities. Market indices co-vary significantly with these returns,
but for certain asset categories there are substantial unexplained residuals. More precise
information on cross-border investment patterns would be helpful in this regard.
International cross-holdings appear to provide diversification against fluctuations in
domestic market returns. Finally, the dynamics of real exchange rates imply that the
properties of real returns are very different for home and foreign investors.



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