Chapter 21 Financial Globalization: Opportunity and Crisis
The international Capital Market and the Gains from trade
International capital markets are a group of markets (in London, Tokyo, New York, Singapore,
and other financial cities) that trade different types of financial and physical capital (assets),
including stocks, bonds (government and corporate), bank deposits denominated in different
currencies, commodities (like petroleum, wheat, bauxite, gold), forward contracts, futures
contracts, swaps, options contracts, real estate and land, factories and equipment.
How have international capital markets increased the gains from trade?
When a buyer and a seller engage in a voluntary transaction, both receive something that they
want and both can be made better off. A buyer and seller can trade goods or services for other
goods or services, goods or services for assets, or assets for assets.
When individuals select assets, an important factor in their decisions is the riskiness of each
asset’s return. Other things equal, people dislike risk. Economists call this property of people’s
preferences risk aversion.
Suppose you are offered a gamble in which you win 1000 half the time but lose 1000 half the
time. Since you are expected as likely to win as to lose the 1000, the average payoff on this
gamble (its expected value) is ½ * 1000 + ½ *(-1000) = 0. If you are risk averse, you will not
take the gamble because, for you, the possibility of losing 1000 outweighs the possibility that
you will win, even though both outcomes are equally likely.
If people are risk averse, they value a collection (or portfolio) of assets not only on the basis of
its expected return but also on the basis of the riskiness of that return. Under risk aversion,
people may be willing to hold bonds denominated in several different currencies, even if the
interest rates they offer are not linked by the interest parity condition, if the resulting portfolio of
assets offers a desirable combination of return and risk. In general, a portfolio whose return
fluctuates wildly from year to year is less desirable than one that offers the same average return
with only mild year-to-year fluctuations. This observation is basic to understanding why
countries exchange assets.
Portfolio Diversification as a Motive for International Asset trade
The theory of
describes the gains from trade of assets for assets, of
assets with one type of risk with assets of another type of risk. Economists say that investors
: they are averse to risk. Diversifying or “mixing up” a portfolio of
assets is a way for investors to avoid or reduce risk.