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The International Diversification Puzzle when Goods Prices Are Sticky

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  • Akito Matsumoto
  • Charles Engel

Abstract

This paper develops a two-country monetary DSGE model in which households choose a portfolio of home and foreign equities, and a forward position in foreign exchange. Some nominal goods prices are sticky. Trade in these assets achieves the same allocations as trade in a complete set of nominal state-contingent claims in our linearized model. When there is a high degree of price stickiness, we show that not much equity diversification is required to replicate the complete-markets equilibrium when agents are able to hedge foreign exchange risk sufficiently. Moreover, temporarily sticky nominal goods prices can have large effects on equity portfolios even when dividend processes are very persistent.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 09/12.

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Length: 47
Date of creation: 01 Jan 2009
Date of revision:
Handle: RePEc:imf:imfwpa:09/12

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Keywords: Private investment; Commodity prices; Asset management; Economic models; exchange rate; hedge; foreign exchange; home currency; nominal exchange rate; cash flow; hedging; real exchange rate; bonds; exchange rates; exchange rate risk; nominal bonds; forward market; asset markets; foreign exchange risk; equity shares; exchange risk; stockholders; hedges; forward contract; foreign exchange markets; stochastic discount; financial markets; money market; exchange rate changes; derivative; exchange rate fluctuations; foreign equity; exchange markets; real exchange rates; bond; stochastic discount factor; exchange rate positions; present value; hedging instrument; forward exchange rate; spot exchange rate; international capital; financial assets; foreign exchange rate; financial globalization; exchange rate shocks; equity markets; forward exchange; exchange rate variability;

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References

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  19. Charles Engel, 2006. "Equivalence Results for Optimal Pass-Through, Optimal Indexing to Exchange Rates, and Optimal Choice of Currency for Export Pricing," Journal of the European Economic Association, MIT Press, vol. 4(6), pages 1249-1260, December.
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