In standard public finance theory a government's cost of borrowing depends on the common beliefs held by rational investors regarding default risk. We advance understanding of the effects of diverse beliefs and overconfidence among investors in their ability to assess the sovereign's creditworthiness. Theoretically, we find that demand for insurance against default is positively related to the absolute difference between the market price of sovereign risk and the risk forecasted by the economy's fundamentals. We find preliminary support for this prediction in a newly available dataset on sovereign credit default swaps (CDSs): after controlling for the size of the public debt, the absolute size of the gap between the actual and forecasted spreads is positively related to the value of outstanding CDSs.

International fund investment in bonds and equities is characterized by a positive association between current net inflows and contemporaneous and past market returns: positive-feedback trading, while being possibly profitable for international fund investors, could be destabilizing for the underlying markets. Allowing for interactions between equity investment and bond investment, our panel vector autoregression shows that past equity returns contain useful information in forecasting equity and bond flows and that bond flows impact future equity returns positively.

Controls on capital inflows have been experiencing a renaissance since 2008, with several prominent emerging markets implementing them in recent years. We focus on Brazil, which instituted five changes in its capital account regime in 2008–2011. Using the synthetic control method, we construct counterfactuals (i.e., Brazil with no policy change) for each of these changes. We find no evidence that any tightening of controls was effective in reducing the magnitudes of capital inflows, but we observe some modest and short-lived success in preventing further declines in inflows when the capital controls were relaxed. We hypothesize that price-based capital controls’ only perceptible effect is to be found in the content of the signal they broadcast regarding the government’s larger intentions and sensibilities. In the case of Brazil, its left-of-center government’s willingness to remove controls was perceived as a noteworthy indication that the government was not as hostile to the international financial markets as many expected it to be.