The International Diversification Puzzle is Not as Bad as You Think

45 Pages Posted: 15 Oct 2007 Last revised: 27 Oct 2007

See all articles by Jonathan Heathcote

Jonathan Heathcote

Minneapolis Fed

Fabrizio Perri

Leonard N. Stern School of Business - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: October 2007

Abstract

In simple one-good international macro models, the presence of non-diversifiable labor income risk means that country portfoliosshould be heavily biased toward foreign assets. The fact that theopposite pattern of diversification is observed empirically constitutes the international diversification puzzle. We embed aportfolio 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 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.

Suggested Citation

Heathcote, Jonathan and Perri, Fabrizio, The International Diversification Puzzle is Not as Bad as You Think (October 2007). NBER Working Paper No. w13483, Available at SSRN: https://ssrn.com/abstract=1020909

Jonathan Heathcote

Minneapolis Fed ( email )

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HOME PAGE: http://www.jonathanheathcote.com

Fabrizio Perri (Contact Author)

Leonard N. Stern School of Business - Department of Economics ( email )

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HOME PAGE: http://www.stern.nyu.edu/~fperri/

National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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