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

37 Pages Posted: 30 Nov 2001

See all articles by Alexander Michaelides

Alexander Michaelides

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

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Date Written: November 2001

Abstract

This Paper solves for optimal international portfolio choice in the presence of liquidity constraints and undiversifiable labour income risk. Optimal portfolios are internationally diversified while positive correlation between domestic stock market returns and permanent labour income shocks can worsen the home equity bias puzzle. Nevertheless, either small costs associated with investing abroad or a slightly positive domestic to foreign equity premium differential are sufficient 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.

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

JEL Classification: E20, G11

Suggested Citation

Michaelides, Alexander, International Portfolio Choice, Liquidity Constraints and the Home Equity Bias Puzzle (November 2001). CEPR Discussion Paper No. 3066. Available at SSRN: https://ssrn.com/abstract=292311

Alexander Michaelides (Contact Author)

Imperial College Business School ( email )

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

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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