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The International Diversification Puzzle Is Not as Bad as You Think

  • Jonathan Heathcote
  • Fabrizio Perri

The international diversification puzzle is the fact that country portfolios are on average biased toward domestic assets, while one-good international macro models with nondiversifiable labor income risk predict the opposite pattern of diversification. This paper embeds a portfolio choice decision in a two-good international business cycle model and provides a closed-form solution for equilibrium country portfolios. Equilibrium portfolios are biased toward domestic assets because endogenous international relative price fluctuations make domestic assets a good hedge against labor income risk. Evidence from developed economies in recent years is qualitatively and quantitatively consistent with the mechanisms highlighted by the theory.

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File URL: http://www.jstor.org/stable/full/10.1086/674143
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Article provided by University of Chicago Press in its journal Journal of Political Economy.

Volume (Year): 121 (2013)
Issue (Month): 6 ()
Pages: 1108 - 1159

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Handle: RePEc:ucp:jpolec:doi:10.1086/674143
Contact details of provider: Web page: http://www.journals.uchicago.edu/JPE/

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