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International portfolio choice, liquidity constraints and the home equity bias puzzle

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  • Michaelides, Alexander

Abstract

This paper solves for optimal international portfolio choice in the presence of liquidity constraints and undiversifiable labor income risk. Optimal portfolios are internationally diversified while positive correlation between domestic stock market returns and permanent labor income shocks can generate a complete portfolio specialization in foreign stocks. Nevertheless, either small costs associated with investing abroad or a slightly positive domestic to foreign equity premium differential are sufficient to either deter households from participating in a foreign market or generate a substantial bias for home equities. The benefits of international diversification are limited because consumption fluctuations can be smoothed with a small amount of buffer stock saving, while exchange rate risk makes foreign investments less appealing to risk averse investors.
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  • Michaelides, Alexander, 2003. "International portfolio choice, liquidity constraints and the home equity bias puzzle," Journal of Economic Dynamics and Control, Elsevier, vol. 28(3), pages 555-594, December.
    • Handle: RePEc:eee:dyncon:v:28:y:2003:i:3:p:555-594
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    Cited by:

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    3. Geromichalos, Athanasios & Simonovska, Ina, 2014. "Asset liquidity and international portfolio choice," Journal of Economic Theory, Elsevier, vol. 151(C), pages 342-380.
    4. Bretscher, Lorenzo & Julliard, Christian & Rosa, Carlo, 2015. "Human capital and international portfolio diversification: a reappraisal," LSE Research Online Documents on Economics 119454, London School of Economics and Political Science, LSE Library.
    5. Haselmann, Rainer & Helmut, Herwartz, 2005. "The Introduction of the Euro and its Effects on Investment Decisions," Economics Working Papers 2005-15, Christian-Albrechts-University of Kiel, Department of Economics.
    6. Massimo Guidolin, 2005. "Home Bias and High Turnover in an Overlapping‐generations Model with Learning," Review of International Economics, Wiley Blackwell, vol. 13(4), pages 725-756, September.
    7. Bretscher, Lorenzo & Julliard, Christian & Rosa, Carlo, 2016. "Human capital and international portfolio diversification: A reappraisal," Journal of International Economics, Elsevier, vol. 99(S1), pages 78-96.
    8. Christelis, Dimitris & Georgarakos, Dimitris, 2013. "Investing at home and abroad: Different costs, different people?," Journal of Banking & Finance, Elsevier, vol. 37(6), pages 2069-2086.
    9. Eduard Gaar & David Scherer & Dirk Schiereck, 2022. "The home bias and the local bias: A survey," Management Review Quarterly, Springer, vol. 72(1), pages 21-57, February.
    10. Julliard, Christian, 2004. "Human capital and international portfolio choice," LSE Research Online Documents on Economics 4813, London School of Economics and Political Science, LSE Library.
    11. Haselmann, Rainer & Herwartz, Helmut, 2010. "The introduction of the Euro and its effects on portfolio decisions," Journal of International Money and Finance, Elsevier, vol. 29(1), pages 94-110, February.
    12. Ricardo M. Sousa, 2011. "Wealth, Labour Income, Stock Returns and Government Bond Yields, and Financial Stress in the Euro Area," NIPE Working Papers 22/2011, NIPE - Universidade do Minho.
    13. Mann, Katja & Davenport, Margaret, 2016. "Demography, Capital Flows and Asset Allocation over the Life-cycle," VfS Annual Conference 2016 (Augsburg): Demographic Change 145948, Verein für Socialpolitik / German Economic Association.
    14. Martin D. D. Evans & Viktoria Hnatkovska, 2005. "Solving General Equilibrium Models with Incomplete Markets and Many Assets," NBER Technical Working Papers 0318, National Bureau of Economic Research, Inc.
    15. Ricardo M. Sousa, 2010. "Time-Varying Expected Returns: Evidence from the U.S. and the U.K," NIPE Working Papers 10/2010, NIPE - Universidade do Minho.
    16. Bravo-Ortega, Claudio, 2005. "Does asymmetric information cause the home equity bias?," Policy Research Working Paper Series 3495, The World Bank.
    17. Haselmann, Rainer & Herwartz, Helmut, 2008. "Portfolio performance and the Euro: Prospects for new potential EMU members," Journal of International Money and Finance, Elsevier, vol. 27(2), pages 314-330, March.
    18. Sirr, Gordon & Garvey, John & Gallagher, Liam, 2011. "Emerging markets and portfolio foreign exchange risk: An empirical investigation using a value-at-risk decomposition technique," Journal of International Money and Finance, Elsevier, vol. 30(8), pages 1749-1772.
    19. Magi, Alessandro, 2009. "Portfolio choice, behavioral preferences and equity home bias," The Quarterly Review of Economics and Finance, Elsevier, vol. 49(2), pages 501-520, May.
    20. Akbar, Ume Salma & Mubashir Ali, Mubashir Ali & Shah, Zulifqar Ali, 2014. "Home Equity Bias," Sukkur IBA Journal of Management and Business, Sukkur IBA University, vol. 1(1), pages 40-56, October.

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    More about this item

    JEL classification:

    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • F39 - International Economics - - International Finance - - - Other
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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