A Dynamic Equilibrium Model of Imperfectly Integrated Financial Markets
AbstractThe goal of this paper is to analyze the determination of countries equity portfolios and countries stock returns behavior in the context of imperfectly integrated financial markets. We build a continuous-time equilibrium model of a two-country endowment economy in which the level of financial integration is simply captured by with holding taxes on foreign dividends. Despite the heterogeneity among investors induced by these taxes, we obtain approximate closed-form expressions for asset prices and we characterize equity holdings and national assets returns behavior in equilibrium. The existence of a friction akin to a with holding tax on foreign dividends has two opposite effects on portfolios: the first mechanical effect is to reduce foreign holdings by reducing expected returns on foreign assets; but there is a second effect, which is to reduce endogenously the correlation between national asset returns, thus increasing the willingness to diversify internationally. Quantitatively, we show that the direct effect dwarfs the indirect effect and we find that, for a reasonably high level of substituability between national assets, small frictions on equity markets can generate a large home bias in portfolios. Empirically, our model is consistent with a broad range of findings on international financial integration. Moreover, we provide an explanation for the puzzling positive relationship that has been found in the data between bilateral equity holdings and bilateral stock returns correlations.
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Bibliographic InfoPaper provided by ESSEC Research Center, ESSEC Business School in its series ESSEC Working Papers with number DR 06014.
Length: 48 pages
Date of creation: Oct 2006
Date of revision:
Asset Pricing with Heterogeneous Investors; Financial Integration; Home Bias in Portfolio; International Stock Returns Correlations; Stochastic Pareto-Negishi Weight;
Other versions of this item:
- Nicolas Coeurdacier & Stéphane Guibaud, 2005. "A dynamic equilibrium model of imperfectly integrated financial markets," PSE Working Papers halshs-00590775, HAL.
- F30 - International Economics - - International Finance - - - General
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-11-18 (All new papers)
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