| Abstract: |
We show that cross-border financial flows arise when levels of financial
innovation differ across countries. Financial integration is a way of sharing
scarce collateral. The ability of one country to leverage and tranche assets
provides attractive financial contracts to investors in the other country, and
general equilibrium effects on prices create opportunities for investors in
the sophisticated country to invest abroad. Foreign demand for collateral and
for collateral-backed financial promises increases the collateral value of
domestic assets, and cheap foreign assets provide attractive returns to
investors who do not demand collateral to issue promises. Gross global flows
respond dynamically to fundamentals, exporting and amplifying financial
volatility. |