International Risk Sharing, Investment Restrictions and Asset Prices

We study investment restrictions in a dynamic, two-country, two-good general equilibrium model. The issues that we are concerned with are the impact of the investment restrictions on the cost of capital, the asset returns' volatilities, the international stock market co-movement, and the optimal timing for removing the investment restrictions. On the timing for removing the investment restrictions, we find that, contrary to some conventional wisdom, it may not be in the interest of the country having the restrictions to remove them immediately. The optimal timing depends on a trade-off between the price impact of the investment restrictions and the loss due to lack of diversification. This result helps us understand why some countries are reluctant to change their protective financial policies. On the stock prices, we find that when the domestic country caps foreign investment in some key industry in the domestic economy, the cost of capital of the protected industry increases, that of the non-protected industry decreases. On the other hand, when imposing restrictions on its residents' foreign investments, the domestic country improves its cost of capital. We also find that by having investment restrictions, countries can reduce stock market co-movement. This result contributes to the debate on why recent crises in international financial markets have had different effects on countries located in same geographical area or having similar economic characteristics.