International Portfolio Choice, Liquidity Constraints and the Home Equity Bias Puzzle

48 Pages Posted: 21 Dec 2000

See all articles by Alexander Michaelides

Alexander Michaelides

Imperial College Business School; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: August 10, 2002

Abstract

This paper solves for optimal international portfolio choice in the presence of liquidity constraints and undiversifiable labor income risk. Optimal portfolios are internationally diversified while positive correlation between domestic stock market returns and permanent labor income shocks can generate a complete portfolio specialization in foreign stocks. Nevertheless, either small costs associated with investing abroad or a slightly positive domestic to foreign equity premium differential are suffcient to either deter households from participating in a foreign market or generate a substantial bias for home equities. The benefits of international diversification are limited because consumption fluctuations can be smoothed with a small amount of buffer stock saving, while exchange rate risk makes foreign investments less appealing to risk averse investors.

Note: Previously titled "International Portfolio Choice and Liquidity Constraints: Can Small Information Costs Explain the Home Equity Bias Puzzle?"

Keywords: International portfolio choice, home equity bias, liquidity constraints, information costs

JEL Classification: E2, F39, G11

Suggested Citation

Michaelides, Alexander, International Portfolio Choice, Liquidity Constraints and the Home Equity Bias Puzzle (August 10, 2002). Available at SSRN: https://ssrn.com/abstract=253917 or http://dx.doi.org/10.2139/ssrn.253917

Alexander Michaelides (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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