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Description:
As in the case with perfect foresight, under conditions of uncertainty investors respond to changes in the assets' relative returns. An increase in the expected return of one asset here typically (if both assets are not perfectly correlated) induces a shift, but not a plunge toward that asset. Even when there are no explicit barriers to capital mobility risk-averse investors choose not to react to return differentials in such an extreme way as in a world with perfect foresight. Uncertainty and risk aversion justify the relatively inelastic response to changes in relative returns. Only risk neutral investors would regard financial assets as perfect substitutes and attempt to eliminate completely differences in expected returns on different assets. International tax arbitrage has to consider the fact that capital assets located in different countries are not perfectly substitutable in portfolios (Slemrod, 1988, p. 138). The more diverse risk characteristics (covariance structures) of financial assets are, the less they have to be considered being perfect substitutes and the easier it should be to tax them differently. The less diverse these characteristics are, the more elastic portfolio investment reacts with respect to changes in relative returns or tax differentials. Portfolio managers need to estimate covariances or betas when optimizing country allocation. However, covariances and betas tend to be intertemporally unstable. When world markets become increasingly integrated single markets typically become more susceptible to the behavior of others.14 Then markets could move in tandem and bivariate correlations of single markets tend to increase. Thus, international systematic risk (average covariance with global market movements) increases and diversification benefits from investing in certain markets get more limited. Certain countries might lose their diversification advantage, because they become closer substitutes to each other and competition for capital increases. Hence, in developed - or fully integrated ...