A Dynamic Equilibrium Model of Imperfectly Integrated Financial Markets

71 Pages Posted: 9 Jan 2015

See all articles by Harjoat Singh Bhamra

Harjoat Singh Bhamra

Imperial College Business School

Nicolas Coeurdacier

London Business School

Stéphane Guibaud

SciencesPo - Department of Economics

Date Written: September 14, 2014

Abstract

This paper analyzes the determination of global equity portfolios and stock returns in the context of imperfectly integrated stock markets. We consider a continuous-time, two-country endowment economy, where the level of financial integration is captured by a proportional tax on foreign dividends. Despite the investor heterogeneity induced by this tax, we obtain approximate closed-form expressions for asset prices, and characterize equity holdings and the joint process followed by country-level stock returns in equilibrium. Our model is consistent with a broad range of empirical findings on international financial integration. When the (endogenous) cross-country return correlation is high, small frictions in equity markets can generate a substantial home bias in portfolios. In the baseline version of our model, the cross-country return correlation is driven by the fundamental correlation and portfolio rebalancing. In a two-good extension of the model, the adjustment of relative good prices can generate a high stock return correlation even for a low level of fundamental correlation, magnifying the impact of the financial friction on portfolios. We assess the quantitative performance of the model in a calibration exercise using data from G7 countries.

Keywords: Two Trees, Asset Pricing with Heterogeneous Investors, Home Bias in Portfolios, International Stock Return Correlations, Financial Integration

JEL Classification: G15, F30, G11, G12

Suggested Citation

Bhamra, Harjoat Singh and Coeurdacier, Nicolas and Guibaud, Stephane, A Dynamic Equilibrium Model of Imperfectly Integrated Financial Markets (September 14, 2014). Journal of Economic Theory, Vol. 154, 2014. Available at SSRN: https://ssrn.com/abstract=2546569

Harjoat Singh Bhamra (Contact Author)

Imperial College Business School ( email )

Tanaka Building
Exhibition Rd
London, SW7 2AZ
United Kingdom

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

Nicolas Coeurdacier

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Stephane Guibaud

SciencesPo - Department of Economics ( email )

28 Rue des Saints-Pères
Paris, 75007
France

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