It has been widely documented that US investors’ net purchases in a foreign equity market co-move positively with returns there. This comovement has been labelled “return chasing”: US investors tend to be net buyers of equity in a foreign country when stock prices there are rising. A common explanation for return chasing is based on the assumption that US investors lack the private information of local investors in foreign markets. In the presence of local private information, less informed US investors react more strongly to public signals than better informed local investors, even if all investors have rational expectations. If public signals are sufficiently important drivers of returns, this mechanism generates both return chasing and under performance of US investors in foreign markets.
While the private information view of international equity markets helps explain return chasing and also equity home bias, it has been challenged by recent empirical findings on investor performance. If local private information were important, domestic investors should make higher trading profits than foreign investors. However, the evidence on the performance of foreign and local investors is mixed, with a number of studies suggesting that foreign investors outperform their domestic counterparts.2 In light of models with local private information, it is puzzling why foreigners should sometimes have country-specific private information that is not available to local investors.
Interest rate changes affect domestic markets as well as foreign currency exchange markets. An important area in international financial research has developed around the interest rate parity conditions between countries. This condition with its two types - covered and uncovered, offers a simple mechanism of understanding the impact that interest rates have on changes in currencies in two countries. The uncovered interest rate parity condition (UIP) states that the difference between expected and actual spot exchange rate on a pair of currency at a future point in time should be equal to the difference in the interest rates between two countries. The UIP suggests that countries with high interest rates should see their currency depreciate, whereas countries with low interest rates are expected to have an appreciating currency.
Most of the research developed shows the failure of the UIP, i.e. countries with high interest rates have appreciating currency. Lothian and Wu (2003) propose that the reason for the violation of the UIP is the particular period of 1970s-1980s when most of the studies were done and the use of USD as a numeraire currency. Their findings show that when the time period is long and one of the currencies is not USD the UIP holds. Regressions with large samples confirm the results that UIP holds in longer periods. Similarly, Bailie and Bollerslev (2000) demonstrate that regressions with small samples point to rejecting the UIP.
The process of economic integration in South Asia gathered momentum with the implementation of the South Asian Preferential Trade Agreement (SAPTA) in 1995 under the broad framework of the South Asian Association for Regional Cooperation (SAARC). SAPTA has, however, come to be viewed as an interim platform in the move towards economic integration in South Asia. In 1996, South Asian governments committed themselves to the creation of a South Asian Free Trade Area (SAFTA). Although it was decided at the ninth SAARC Summit to establish SAFTA by 2001, this has proved too ambitious a target. The Eminent Persons Group appointed to examine the implications of the transition to SAFTA recommended that the timeframe be revised, for the non-Least Developed Country (LDC) states of SAARC to have free trade with members by 2008 and for LDC member states to follow by 2010.
Both theory and evidence from regional integration arrangements suggest that measures that reduce trade costs among partner countries may provide an important stimulus not only to trade, but also to foreign direct investment (FDI). Also, specific regional integration initiatives can influence the level and pattern of FDI flows between member countries, as well as, between member countries and outsiders. The SAARC integration initiatives have taken place in the context of a significant (non-discriminatory) liberalisation process in all member countries. This has involved both trade and investment liberalisation, and the adoption of a pro-FDI stance. Though significant trade and investment barriers remain in place in many countries, the regional economies are today far more open than they were until the late 1980s. There is a general acceptance that expanded trade, as well as FDI, confers large net benefits However, though intra SAARC trade has been quite extensively analysed, the FDI-trade nexus has received relatively little research attention in South Asia.
