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THE GLOBAL CAPITAL MARKET: Market Failures and the Policy Response 2

What explain the apparent failure of people to take full advantage of such an obvious opportunity for mutual gain? Nobody knows. Part of the puzzle could reflect the fact that increasingly the profit streams associated with “domestic” companies in fact reflect production operations abroad. And foreign direct investment is indeed substantial. People can and do diversify abroad by holding foreign non-equity assets. In addition, estimates of supposedly optimal portfolios are quite imprecise, and can encompass wealth allocations heavily skewed toward home-based industries. Nonetheless, the weight of the evidence suggests significant unexploited diversification opportunities (Lewis, 1997).

Unfamiliarity with foreign products, firms, business practices, accounting standards, political trends, and regulatory environments surely play some role. An American investor, for example, may feel disadvantaged in assessing the future prospects of a French firm, and may find the cost of becoming informed excessive. Many industrial-country stock exchanges now have substantial listings of foreign firms, but outside of London, that development hasn’t led to substantial domestic trade in their shares. For example, the Amsterdam market’s listings in 1996 were divided about equally between domestic and foreign companies, yet more than 99 percent of its turnover that year was in domestic shares (Folkerts-Landau et al., 1997, p. 198).

The puzzle therefore remains. At present the global capital market enforces rather tight arbitrage among the returns on standardized securities that are subject to risks along only a few well-understood (and easily hedged) dimensions. But such trades go only a small way toward realizing the potential gains from risk sharing. International trade in less homogeneous and riskier assets is growing all the time, but remains less developed.