The International Diversification Puzzle is Not as Bad as You Think
Minneapolis Fed; Georgetown University - Department of Economics
Leonard N. Stern School of Business - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
In simple one-good international macro models, the presence of non-diversifiable labor income risk means that country portfolios should be heavily biased toward foreign assets. The fact that the opposite pattern of diversification is observed empirically constitutes the international diversification puzzle. We embed a portfolio choice decision in a frictionless two-country, two-good version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, we derive a closed-form expression for equilibrium country portfolios. These are biased towards domestic assets, as in the data. Home bias arises because endogenous international relative price fluctuations make domestic stocks a good hedge against non-diversifiable labor income risk. We then use our theory to link openness to trade to the level of diversification, and find that it offers a quantitatively compelling account for the patterns of international diversification observed across developed economies in recent years.
Keywords: Home Bias, international diversification
JEL Classification: F36, F41working papers series
Date posted: July 19, 2008
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