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Equity home bias, incomplete financial markets, and nominal rigidities

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  • Ke Pang

Abstract

This paper analyzes optimal portfolio decisions in a monetary open-economy framework. It is found that market completeness and the specific form of nominal rigidities, namely, nominal price vs. nominal wage rigidities, matter for justifying the observed structure of equity holdings. When markets are complete, sticky prices generate a negative correlation between the non-diversifiable labour income and the profit of domestic firms with respect to the productivity shocks, which explains why households invest little abroad. In contrast, when markets are incomplete, rigidities in goods prices result in a counterfactual `super home bias', because domestic equities provide a good hedge against not only the labour income risk but also the relative price risk. Wage rigidities, however, have the opposite effect. Therefore, nominal rigidities in both goods prices and wage rates are needed to address the empirical composition of gross equity positions under incomplete markets.

Suggested Citation

  • Ke Pang, 2011. "Equity home bias, incomplete financial markets, and nominal rigidities," Canadian Journal of Economics, Canadian Economics Association, vol. 44(1), pages 340-363, February.
    • Handle: RePEc:cje:issued:v:44:y:2011:i:1:p:340-363
    DOI: 10.1111/j.1540-5982.2010.01635.x
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    More about this item

    JEL classification:

    • F30 - International Economics - - International Finance - - - General
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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