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The International Diversification Puzzle When Goods Prices Are Sticky: It's Really about Exchange-Rate Hedging, Not Equity Portfolios

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  • Charles Engel
  • Akito Matsumoto

Abstract

This paper develops a two-country monetary DSGE model in which households choose a portfolio of home and foreign equities, and a forward position in foreign exchange. Some nominal goods prices are sticky. Trade in these assets achieves the same allocations as trade in a complete set of nominal state-contingent claims in our linearized model. When there is a high degree of price stickiness, we show that not much equity diversification is required to replicate the complete-markets equilibrium when agents are able to hedge foreign exchange risk sufficiently. Moreover, temporarily sticky nominal goods prices can have large effects on equity portfolios even when dividend processes are very persistent. (JEL E13, F41, G11, G15)

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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Journal: Macroeconomics.

Volume (Year): 1 (2009)
Issue (Month): 2 (July)
Pages: 155-88

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Handle: RePEc:aea:aejmac:v:1:y:2009:i:2:p:155-88

Note: DOI: 10.1257/mac.1.2.155
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  1. V. V Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Oxford University Press, vol. 69(3), pages 533-563.
  2. Hanno Lustig & Stijn Van Nieuwerburgh, 2008. "The Returns on Human Capital: Good News on Wall Street is Bad News on Main Street," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 21(5), pages 2097-2137, September.
  3. Jonathan Heathcote & Fabrizio Perri, 2007. "The International Diversification Puzzle Is Not As Bad As You Think," NBER Working Papers 13483, National Bureau of Economic Research, Inc.
  4. Bergin, Paul R., 2006. "How well can the New Open Economy Macroeconomics explain the exchange rate and current account?," Journal of International Money and Finance, Elsevier, Elsevier, vol. 25(5), pages 675-701, August.
  5. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 28(1), pages 3-24, August.
  6. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262150476, December.
  7. Ignacio Palacios-Huerta, 2001. "The Human Capital of Stockholders and the International Diversification Puzzle," Working Papers 2001-13, Brown University, Department of Economics.
  8. Tesar, Linda L., 1993. "International risk-sharing and non-traded goods," Journal of International Economics, Elsevier, Elsevier, vol. 35(1-2), pages 69-89, August.
  9. Huang, Kevin X.D. & Liu, Zheng, 2005. "Inflation targeting: What inflation rate to target?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 52(8), pages 1435-1462, November.
  10. Coeurdacier, Nicolas & Kollmann, Robert & Martin, Philippe, 2007. "International Portfolios with Supply, Demand and Redistributive Shocks," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6482, C.E.P.R. Discussion Papers.
  11. Lewis, Karen K., 2000. "Why do stocks and consumption imply such different gains from international risk sharing?," Journal of International Economics, Elsevier, Elsevier, vol. 52(1), pages 1-35, October.
  12. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, Elsevier, vol. 10(3), pages 335-359.
  13. Stockman, Alan C. & Dellas, Harris, 1989. "International portfolio nondiversification and exchange rate variability," Journal of International Economics, Elsevier, Elsevier, vol. 26(3-4), pages 271-289, May.
  14. Eldor, Rafael & Pines, David & Schwartz, Abba, 1988. "Home asset preference and productivity shocks," Journal of International Economics, Elsevier, Elsevier, vol. 25(1-2), pages 165-176, August.
  15. Karen K. Lewis, 1999. "Trying to Explain Home Bias in Equities and Consumption," Journal of Economic Literature, American Economic Association, American Economic Association, vol. 37(2), pages 571-608, June.
  16. Warnock, Francis E., 2002. "Home bias and high turnover reconsidered," Journal of International Money and Finance, Elsevier, Elsevier, vol. 21(6), pages 795-805, November.
  17. Christian Julliard, 2002. "The international diversification puzzle is not worse than you think," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 4814, London School of Economics and Political Science, LSE Library.
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