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International Diversification in Debt vs Equity

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Abstract

Can a standard open economy macro model generate realistic international diversification in debt AND equity? We address this question by solving for steady-state portfolios in a two-country, two-good DSGE endowment model with consumption home bias. We compare two different asset trading regimes. In the first, households in each country trade equity claims on their underlying stochastic endowments; in the second, households trade locally-denominated bonds. We derive locally accurate closed-form solutions for steady-state portfolios under each regime. The model can predict realistic home equity bias and bond diversification if the intratemporal elasticity of substitution between home and foreign goods is sufficiently low. However, for commonly used parameter values, the standard two-good model understates bond diversification and overstates equity diversification. Classification-JEL Codes: F36, F41, G11

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Bibliographic Info

Paper provided by Georgetown University, Department of Economics in its series Working Papers with number gueconwpa~09-09-01.

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Date of creation: 01 Sep 2009
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Handle: RePEc:geo:guwopa:gueconwpa~09-09-01

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Postal: Georgetown University Department of Economics Washington, DC 20057-1036
Phone: 202-687-6074
Fax: 202-687-6102
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Web page: http://econ.georgetown.edu/

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Postal: Marcia Suss Administrative Officer Georgetown University Department of Economics Washington, DC 20057-1036
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Web: http://econ.georgetown.edu/

Related research

Keywords: Home bias; international diversification puzzle; portfolio choice; open economy macroeconomics; DSGE models;

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References

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  1. Pierre-Olivier Gourinchas & Nicolas Coeurdacier, 2008. "When Bonds Matter: Home Bias in Goods and Assets," 2008 Meeting Papers 342, Society for Economic Dynamics.
  2. Coeurdacier, Nicolas & Kollmann, Robert Miguel W. K. & Martin, Philippe J., 2008. "International portfolios, capital accumulation and foreign assets dynamics," Discussion Paper Series 1: Economic Studies 2008,19, Deutsche Bundesbank, Research Centre.
  3. Marianne Baxter & Urban J. Jermann, 1995. "The International Diversification Puzzle is Worse Than You Think," NBER Working Papers 5019, National Bureau of Economic Research, Inc.
  4. Roberto Rigobon & Anna Pavlova, 2004. "Asset Prices and Exchange Rates," Econometric Society 2004 North American Winter Meetings 579, Econometric Society.
  5. Coeurdacier, Nicolas, 2008. "Do Trade Costs in Goods Market Lead to Home Bias in Equities?," CEPR Discussion Papers 6991, C.E.P.R. Discussion Papers.
  6. Martin D. D. Evans (Georgetown University) and Viktoria Hnatkovska (Georgetown University), 2005. "International Capital Flows, Returns and World Financial Integration," Working Papers gueconwpa~05-05-17, Georgetown University, Department of Economics.
  7. 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.
  8. Akito Matsumoto & Charles Engel, 2005. "Portfolio Choice in a Monetary Open-Economy DSGE Model," IMF Working Papers 05/165, International Monetary Fund.
  9. Michael B. Devereux & Alan Sutherland, 2007. "Solving for Country Portfolios in Open Economy Macro Models," IMF Working Papers 07/284, International Monetary Fund.
  10. Kollmann, Robert, 2006. "International Portfolio Equilibrium and the Current Account," CEPR Discussion Papers 5512, C.E.P.R. Discussion Papers.
  11. repec:spo:wpecon:info:hdl:2441/c8dmi8nm4pdjkuc9g708n2m4m is not listed on IDEAS
  12. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  13. Hnatkovska, Viktoria, 2010. "Home bias and high turnover: Dynamic portfolio choice with incomplete markets," Journal of International Economics, Elsevier, vol. 80(1), pages 113-128, January.
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