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A dynamic equilibrium of imperfectly integrated financial markets

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  • Stéphane Guibaud

    (Department of Finance)

  • Nicolas Coeurdacier

Abstract

This paper analyzes the determination of equity portfolios and country stock returns in the context of imperfectly integrated stock markets. We consider a continuous-time model of a two-country endowment economy in which the level of financial integration is captured by a proportional tax on foreign dividends. Despite the heterogeneity among investors induced by this tax, we obtain approximate closed-form expressions for asset prices and we characterize equity holdings and the joint process followed by country stock returns in equilibrium. Our model is consistent with a broad range of empirical findings on international financial integration. When the (endogenous) cross-country return correlation is high, small frictions in equity markets can generate a substantial home bias in portfolios. In the baseline version of our model, the cross- country return correlation is driven by fundamental correlation and portfolio rebalancing. In a two-good extension of the model, the adjustment of relative good prices can generate high stock return correlation even for a low level of fundamental correlation, thus magnifying the impact of the financial friction on portfolios.

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Paper provided by Sciences Po in its series Sciences Po publications with number info:hdl:2441/c8dmi8nm4pdjkuc9g81p80a37.

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Date of creation: Oct 2008
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Handle: RePEc:spo:wpmain:info:hdl:2441/c8dmi8nm4pdjkuc9g81p80a37

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Related research

Keywords: Two Trees; Asset Pricing with Heterogenous Investors; Home Bias in Portfolios; International Stock Return Correlations; Financial Integration;

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References

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  1. Antonin Aviat & Nicolas Coeurdacier, 2004. "The geography of trade in goods and asset holdings," DELTA Working Papers, DELTA (Ecole normale supérieure) 2004-10, DELTA (Ecole normale supérieure).
  2. Rene M. Stulz, 1999. "Globalization of Equity Markets and the Cost of Capital," NBER Working Papers 7021, National Bureau of Economic Research, Inc.
  3. Martin, Philippe & Rey, Hélène, 1999. "Financial Super-Markets: Size Matters for Asset Trade," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2232, C.E.P.R. Discussion Papers.
  4. Charles Engel & Akito Matsumoto, 2006. "Portfolio Choice in a Monetary Open-Economy DSGE Model," NBER Working Papers 12214, National Bureau of Economic Research, Inc.
  5. Ian Martin, 2013. "The Lucas Orchard," Econometrica, Econometric Society, Econometric Society, vol. 81(1), pages 55-111, 01.
  6. Harald Hau & Helene Rey, 2004. "Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows, and Exchange Rates?," NBER Working Papers 10476, National Bureau of Economic Research, Inc.
  7. Basak, Suleyman & Cuoco, Domenico, 1998. "An Equilibrium Model with Restricted Stock Market Participation," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 11(2), pages 309-41.
  8. Eun, Cheol S & Janakiramanan, S, 1986. " A Model of International Asset Pricing with a Constraint on the Foreign Equity Ownership," Journal of Finance, American Finance Association, American Finance Association, vol. 41(4), pages 897-914, September.
  9. Baxter, Marianne & Jermann, Urban J. & King, Robert G., 1998. "Nontraded goods, nontraded factors, and international non-diversification," Journal of International Economics, Elsevier, Elsevier, vol. 44(2), pages 211-229, April.
  10. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, Econometric Society, vol. 46(6), pages 1429-45, November.
  11. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 28(1), pages 3-24, August.
  12. Kaminsky, Graciela Laura & Schmukler, Sergio L., 2002. "Short-run pain, long-run gain : the effects of financial liberalization," Policy Research Working Paper Series, The World Bank 2912, The World Bank.
  13. Stockman, Alan C. & Dellas, Harris, 1989. "International portfolio nondiversification and exchange rate variability," Journal of International Economics, Elsevier, Elsevier, vol. 26(3-4), pages 271-289, May.
  14. Hietala, Pekka T, 1989. " Asset Pricing in Partially Segmented Markets: Evidence from the Finnish Market," Journal of Finance, American Finance Association, American Finance Association, vol. 44(3), pages 697-718, July.
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Cited by:
  1. Eric Van Wincoop & Cedric Tille, 2007. "International Capital Flows," NBER Working Papers 12856, National Bureau of Economic Research, Inc.

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