Emerging market financial crises are abrupt and dramatic, usually occurring after a period of high output growth, massive capital flows, and a boom in asset markets. This thesis develops an equilibrium asset pricing model with informational frictions in which vulnerability and the crisis itself are consequences of the investor optimism in the period preceding the crisis. The model features two sets of investors, domestic and foreign. Both sets of investors are imperfectly informed about the true state of the emerging economy. Investors learn from noisy signals which contain information relevant for asset returns and formulate expectations, or beliefs, about the state of productivity.
Numerical analysis shows that, if preceded by a sequence of positive signals, a
small, negative noise shock can trigger a sharp downward adjustment in investors'
beliefs, asset prices, and consumption. The magnitude of this downward adjust-
ment and sensitivity to negative signals increase with the level of optimism attained
prior to the negative signal. The model calibrated to a typical emerging market economy, Turkey, reveals that with the introduction of incomplete information asset
prices display persistent e®ects in response to transitory shocks, and the volatility of consumption increases by 2.1 percentage points.
The maximum likelihood estimation of the model's parameters using U.S. data
documents that the estimated signal-to-noise ratio for the U.S. is higher since, unlike
Turkey, a signi¯cantly higher portion of fluctuations can be accounted for by changes
in the persistent component rather than the noise. Feeding these two different signal-to-noise ratios to the model, we ¯nd that the booms and busts driven by misperceptions of the investors have signi¯cantly lower frequency, magnitude, and duration in the case of U.S. compared to Turkey.
The economy has two classes of agents, foreign investors and domestic household-
investors, who are identical within each class. The domestic households maximize
expected lifetime utility by making consumption and asset holding decisions condi-
tional on their information set, that includes the noisy signals about the true state of productivity. Foreign investors choose their asset positions in order to maximize the expected present discounted value of profits based on their beliefs about the state of productivity. Foreign investors also face trading costs associated with op erating in the asset market. Neither domestic nor foreign investors observe the true realization of the stochastic productivity shock, which contains information relevant for forecasting the returns from the asset. They only observe dividends, which are noisy signals about the true value of productivity. Foreign and domestic investors form their beliefs by solving a signal extraction problem.
The boom-bust cycles of emerging economies suggest that periods of apparent prosperity in these countries might contain the seeds of crises. This thesis explores this possibility using an open economy equilibrium asset pricing model with im perfect information in which agents do not know the true state of productivity in the economy. The model proposed in this thesis can endogeously generate periods of optimism characterized by booms in asset prices and consumption followed by sudden reversals, and sensitivity to negative signals that increases with, and arises from, investor optimism attained prior to the negative signal. These results are due to the fact that informational frictions generate a disconnect between country fun- damentals and asset prices. That is, busts (booms) in asset markets can occur even though the fundamentals of the economy are strong (weak). Asset prices display persistence in response to transitory shocks since investors cannot perfectly iden- tify the underlying state of productivity.
Author: Emine Boz, Doctor of Philosophy, 2006