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International Portfolio Allocation under Model Uncertainty

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Author Info
Pierpaolo Benigno
Salvatore Nisticò

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Abstract

This paper proposes an explanation of the international home bias in equity based on ambiguity aversion. We develop a simple dynamic model of consumption and portfolio decisions and derive the optimal portfolio allocation in terms of covariances between excess returns and the implied sources of risk. Under rational expectations and log utility, the only relevant risk underlying portfolio choices arises from fluctuations in non-tradeable labor income. We find that this hedging motif is empirically too weak to explain the observed lack of international diversification in equity portfolios. On the other hand, in an economy populated by ambiguity-averse agents, model uncertainty becomes an additional hedging reason which translates into long-run real exchange rate risk and is relevant even under log utility. We calibrate the degree of ambiguity aversion using detection error probabilities, and show that our framework is able to explain a large share of the observed U.S. home bias, as well as other stylized facts on U.S. cross-border asset holdings.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14734.

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Date of creation: Feb 2009
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Handle: RePEc:nbr:nberwo:14734

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Find related papers by JEL classification:
F3 - International Economics - - International Finance
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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This page was last updated on 2009-11-25.

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