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International portfolio choice, liquidity constraints and the home equity bias puzzle

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  • Michaelides, Alexander

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.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 28 (2003)
Issue (Month): 3 (December)
Pages: 555-594

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Handle: RePEc:eee:dyncon:v:28:y:2003:i:3:p:555-594

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Citations

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Cited by:
  1. Jonathan Heathcote & Fabrizio Perri, 2007. "The international diversification puzzle is not as bad as you think," Staff Report 398, Federal Reserve Bank of Minneapolis.
  2. Martin D. D. Evans & Viktoria Hnatkovska, 2005. "Solving General Equilibrium Models with Incomplete Markets and Many Assets," NBER Technical Working Papers 0318, National Bureau of Economic Research, Inc.
  3. Christian Julliard, 2004. "Human capital and international portfolio choice," LSE Research Online Documents on Economics 4813, London School of Economics and Political Science, LSE Library.
  4. Bravo-Ortega, Claudio, 2005. "Does asymmetric information cause the home equity bias?," Policy Research Working Paper Series 3495, The World Bank.
  5. Sirr, Gordon & Garvey, John & Gallagher, Liam, 2011. "Emerging markets and portfolio foreign exchange risk: An empirical investigation using a value-at-risk decomposition technique," Journal of International Money and Finance, Elsevier, vol. 30(8), pages 1749-1772.
  6. Massimo Guidolin, 2005. "Home bias and high turnover in an overlapping generations model with learning," Working Papers 2005-012, Federal Reserve Bank of St. Louis.
  7. Ricardo M. Sousa, 2011. "Wealth, Labour Income, Stock Returns and Government Bond Yields, and Financial Stress in the Euro Area," NIPE Working Papers 22/2011, NIPE - Universidade do Minho.
  8. Dimitrios Christelis & Dimitris Georgarakos, 2008. "Investing at Home and Abroad: Different Costs, Different People?," CSEF Working Papers 188, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy, revised 10 Jan 2013.
  9. Haselmann, Rainer & Herwartz, Helmut, 2010. "The introduction of the Euro and its effects on portfolio decisions," Journal of International Money and Finance, Elsevier, vol. 29(1), pages 94-110, February.
  10. Magi, Alessandro, 2009. "Portfolio choice, behavioral preferences and equity home bias," The Quarterly Review of Economics and Finance, Elsevier, vol. 49(2), pages 501-520, May.
  11. Haselmann, Rainer & Helmut, Herwartz, 2005. "The Introduction of the Euro and its Effects on Investment Decisions," Economics Working Papers 2005,15, Christian-Albrechts-University of Kiel, Department of Economics.
  12. Haselmann, Rainer & Herwartz, Helmut, 2008. "Portfolio performance and the Euro: Prospects for new potential EMU members," Journal of International Money and Finance, Elsevier, vol. 27(2), pages 314-330, March.

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