International Portfolio Diversification with Generalized Expected Utility Preferences
AbstractThis paper revisits the Home Bias Puzzle -- the relatively low interna- tional diversification of portfolios. We suggest that part of the diversifi- cation puzzle may be due to reliance on the conventional CAPM model as the benchmark predicting patterns of diversification. We compare the asset diver- sification patterns of agents who maximize a generalized expected utility (GEU) to the diversification of agents who maximize the conventional expected utility (EU). Specifically, we derive the patterns of diversification for agents who maximize a rank-dependent' expected utility, attaching more weight to bad' than to good' outcomes, in contrast to the probability weights used in a conventional expected utility maximization. We show that agents who maximize a GEU exhibit first order risk aversion and tend to refrain from di- versification in contrast to the diversification of agents who maximize the EU. For a given covariance structure we identify a `cone of diversifica- tion -- the range of domestic and foreign yields leading to a positive demand for both equities. Greater downside risk aversion increases the threshold of yields leading to diversification, shifting the cone of diversification upwards and rightwards. Thus, greater downsiderisk aversion narrows the range of foreign yields leading to diversification for a given domestic yield. Ceteris paribus, greater downside risk aversion reduces the feasible hetero- geneity of normalized excess yields associated with diversification. Conse- quently, we argue that first order risk aversion should be added to the explanatory factors that account for the observed diversification patterns.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5965.
Date of creation: Mar 1997
Date of revision:
Contact details of provider:
Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
Web page: http://www.nber.org
More information through EDIRC
Other versions of this item:
- Joshua Aizenman, 1999. "International Portfolio Diversification with Generalized Expected Utility Preferences," Canadian Journal of Economics, Canadian Economics Association, vol. 32(4), pages 995-1008, August.
- F30 - International Economics - - International Finance - - - General
- F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Hong, Chew Soo & Karni, Edi & Safra, Zvi, 1987. "Risk aversion in the theory of expected utility with rank dependent probabilities," Journal of Economic Theory, Elsevier, vol. 42(2), pages 370-381, August.
- Daniel Ellsberg, 2000. "Risk, Ambiguity and the Savage Axioms," Levine's Working Paper Archive 7605, David K. Levine.
- Harold L. Cole & Maurice Obstfeld, 1991.
"Commodity Trade and International Risk Sharing: How Much Do Financial Markets Matter?,"
NBER Working Papers
3027, National Bureau of Economic Research, Inc.
- Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 3-24, August.
- Tesar, Linda L. & Werner, Ingrid M., 1995. "Home bias and high turnover," Journal of International Money and Finance, Elsevier, vol. 14(4), pages 467-492, August.
- Marianne Baxter & Urban J. Jermann & Robert G. King, 1995.
"Nontraded Goods, Nontraded Factors, and International Non-Diversification,"
NBER Working Papers
5175, National Bureau of Economic Research, Inc.
- Baxter, Marianne & Jermann, Urban J. & King, Robert G., 1998. "Nontraded goods, nontraded factors, and international non-diversification," Journal of International Economics, Elsevier, vol. 44(2), pages 211-229, April.
- Stockman, Alan C. & Dellas, Harris, 1989. "International portfolio nondiversification and exchange rate variability," Journal of International Economics, Elsevier, vol. 26(3-4), pages 271-289, May.
- Joshua Aizenman, 1995. "Optimal Buffer Stocks and Precautionary Savings with Disappointment Aversion," NBER Working Papers 5361, National Bureau of Economic Research, Inc.
- Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
- Harless, David W & Camerer, Colin F, 1994. "The Predictive Utility of Generalized Expected Utility Theories," Econometrica, Econometric Society, vol. 62(6), pages 1251-89, November.
- Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, January.
- Kahneman, Daniel & Knetsch, Jack L & Thaler, Richard H, 1990. "Experimental Tests of the Endowment Effect and the Coase Theorem," Journal of Political Economy, University of Chicago Press, vol. 98(6), pages 1325-48, December.
- Stijn Claessens & Moon-Whoan Rhee, 1993. "The Effect of Equity Barriers on Foreign Investment in Developing Countries," NBER Working Papers 4579, National Bureau of Economic Research, Inc.
- Amadi, Amir A. & Bergin, Paul R., 2008.
"Understanding international portfolio diversification and turnover rates,"
Journal of International Financial Markets, Institutions and Money,
Elsevier, vol. 18(2), pages 191-206, April.
- Amir Amadi & Paul Bergin, 2006. "Understanding International Portfolio Diversification and Turnover Rates," NBER Working Papers 12473, National Bureau of Economic Research, Inc.
- Akito Matsumoto & Charles Engel, 2005.
"Portfolio Choice in a Monetary Open-Economy DSGE Model,"
IMF Working Papers
05/165, International Monetary Fund.
- Charles Engel & Akito Matsumoto, 2006. "Portfolio Choice in a Monetary Open-Economy DSGE Model," NBER Working Papers 12214, National Bureau of Economic Research, Inc.
- Kimakova, Alena, 2008. "The political economy of exchange rate regime determination: Theory and evidence," Economic Systems, Elsevier, vol. 32(4), pages 354-371, December.
- Glabadanidis, Paskalis, 2009. "Measuring the economic significance of mean-variance spanning," The Quarterly Review of Economics and Finance, Elsevier, vol. 49(2), pages 596-616, May.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ().
If references are entirely missing, you can add them using this form.