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The International Diversification Puzzle When Goods Prices Are Sticky: It's Really about Exchange-Rate Hedging, Not Equity Portfolios

  • Charles Engel
  • Akito Matsumoto

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. (JEL E13, F41, G11, G15)

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/mac.1.2.155
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Article provided by American Economic Association in its journal American Economic Journal: Macroeconomics.

Volume (Year): 1 (2009)
Issue (Month): 2 (July)
Pages: 155-88

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Handle: RePEc:aea:aejmac:v:1:y:2009:i:2:p:155-88
Note: DOI: 10.1257/mac.1.2.155
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  8. Palacios-Huerta, Ignacio, 2001. "The human capital of stockholders and the international diversification puzzle," Journal of International Economics, Elsevier, vol. 54(2), pages 309-331, August.
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  10. Lewis, Karen K., 2000. "Why do stocks and consumption imply such different gains from international risk sharing?," Journal of International Economics, Elsevier, vol. 52(1), pages 1-35, October.
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  12. 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.
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  16. 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.
  17. Karen K. Lewis, 1999. "Trying to Explain Home Bias in Equities and Consumption," Journal of Economic Literature, American Economic Association, vol. 37(2), pages 571-608, June.
  18. Eldor, Rafael & Pines, David & Schwartz, Abba, 1988. "Home asset preference and productivity shocks," Journal of International Economics, Elsevier, vol. 25(1-2), pages 165-176, August.
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