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

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Michaelides, Alexander

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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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3066.

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Date of creation: Nov 2001
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Handle: RePEc:cpr:ceprdp:3066

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Related research
Keywords: home equity bias; information costs; international portfolio choice; liquidity constraints;

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Find related papers by JEL classification:
E20 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - General (includes Measurement and Data)
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

Cited by:
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  1. Fabrizio Perri & Jonathan Heathcote, 2007. "The International Diversification Puzzle Is Not as Bad as You Think," Working Papers 2007-3, University of Minnesota, Department of Economics, revised 08 Oct 2007. [Downloadable!]
    Other versions:
  2. 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. [Downloadable!]
  3. 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. [Downloadable!] (restricted)
    Other versions:
  4. Bravo-Ortega, Claudio, 2005. "Does asymmetric information cause the home equity bias?," Policy Research Working Paper Series 3495, The World Bank. [Downloadable!]
  5. 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. [Downloadable!]
    Other versions:
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