A Dynamic Equilibrium Model of Imperfectly Integrated Financial Markets
71 Pages Posted: 9 Jan 2015
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: Suggested Citation
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