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International Portfolio Allocation under Model Uncertainty

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  • Pierpaolo Benigno
  • Salvatore Nistic�

Abstract

This paper revisits an old argument, hedging real exchange rate risk, as an explanation of the international home bias in equity. In a dynamic model, the relevant risk to be hedged is the long-run risk as opposed to the short-run risk. Domestic equity is indeed a good hedge with respect to long-run real-exchange-rate risk. Two new frameworks are able to explain a large share of the observed US home bias: a model with Hansen-Sargent preferences in which agents fear model misspecification and a model with Epstein-Zin preferences. These two models are also immune to the risk-free rate puzzle. (JEL C58, F31, G11, G15)

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Bibliographic Info

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

Volume (Year): 4 (2012)
Issue (Month): 1 (January)
Pages: 144-89

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Handle: RePEc:aea:aejmac:v:4:y:2012:i:1:p:144-89

Note: DOI: 10.1257/mac.4.1.144
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  1. Giannis Vardas & Anastasios Xepapadeas, 2004. "Uncertainty Aversion and Robust Portfolio Choices," Working Papers, University of Crete, Department of Economics 0408, University of Crete, Department of Economics.
  2. David K. Backus & Bryan R. Routledge & Stanley E. Zin, 2005. "Exotic Preferences for Macroeconomists," NBER Chapters, in: NBER Macroeconomics Annual 2004, Volume 19, pages 319-414 National Bureau of Economic Research, Inc.
  3. Michael B. Devereux & Alan Sutherland, 2011. "Country Portfolios In Open Economy Macro‐Models," Journal of the European Economic Association, European Economic Association, European Economic Association, vol. 9(2), pages 337-369, 04.
  4. Kollmann, Robert, 2006. "International Portfolio Equilibrium and the Current Account," CEPR Discussion Papers, C.E.P.R. Discussion Papers 5512, C.E.P.R. Discussion Papers.
  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. Robert J. Shiller, 1993. "Aggregate Income Risks and Hedging Mechanisms," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1048, Cowles Foundation for Research in Economics, Yale University.
  7. 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.
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  9. Tomasz Strzalecki, 2011. "Axiomatic Foundations of Multiplier Preferences," Levine's Working Paper Archive 786969000000000126, David K. Levine.
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  11. Tomasz Strzalecki, . "Temporal Resolution of Uncertainty and Recursive Models of Ambiguity Aversion," Working Paper 8240, Harvard University OpenScholar.
  12. Hansen, Lars Peter & Sargent, Thomas J., 2005. "Robust estimation and control under commitment," Journal of Economic Theory, Elsevier, Elsevier, vol. 124(2), pages 258-301, October.
  13. Riccardo Colacito & Mariano M. Croce, 2011. "Risks for the Long Run and the Real Exchange Rate," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 119(1), pages 153 - 181.
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