Center for International and Development Economics Research

This paper presents a new theoretical framework to analyze financial markets in an international context. We build a two-country macroeconomic model in which agents are risk averse, assets are imperfect substitutes, the number of financial assets is endogenous, and cross-border asset trade entails transaction costs. We show that demand effects have important implications for the link between market size, asset prices and financial market development. These effects are consistent with the existing empirical evidence. Due to co-ordination failures, the extent of financial market incompleteness is inefficiently high. We also analyze the impact of domestic transaction costs and issuing costs on financial markets and returns.