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A Portfolio Theory of International Capital Flows

  • Devereux, Michael B
  • Saito, Makoto

Recent global imbalances and large gross external financial movements have raised interest in modeling the relationship between international financial market structure and capital flows. This paper constructs a model in which the composition of national portfolios is an essential element in facilitating international capital flows. Each country chooses an optimal portfolio in face of real and nominal risk. Current account deficits are financed by net capital flows which reflect differential movements in the holdings of gross external assets and liabilities. A country experiencing a current account deficit will be accumulating both gross external liabilities and gross external assets. Net capital flows generate movements in risk premiums such that the rate of return on a debtor country's gross liabilities is lower than the return on its gross assets. This ensures stability of the world wealth distribution. An attractive feature of the model is that portfolio shares, returns, and the wealth distribution can be characterized analytically. A calibrated version of the model can match quite well the observed measures of gross and net external assets and liabilities for the US economy.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5746.

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Date of creation: Jul 2006
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Handle: RePEc:cpr:ceprdp:5746
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  1. Maurice Obstfeld and Kenneth Rogoff., 1994. "The Intertemporal Approach to the Current Account," Center for International and Development Economics Research (CIDER) Working Papers C94-044, University of California at Berkeley.
  2. Pierre-Olivier Gourinchas & Hélène Rey, 2005. "International financial adjustment," Proceedings, Federal Reserve Bank of San Francisco.
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  12. Neumeyer, P.A., 1995. "Currencies and the Allocation of Risk: The Welfare Effect of a Monetary Union," DELTA Working Papers 95-27, DELTA (Ecole normale supérieure).
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  14. Akito Matsumoto & Charles Engel, 2005. "Portfolio Choice in a Monetary Open-Economy DSGE Model," IMF Working Papers 05/165, International Monetary Fund.
  15. Saito, Makoto, 1997. "A note on ergodic distributions in two-agent economies," Journal of Mathematical Economics, Elsevier, vol. 27(2), pages 133-141, March.
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  17. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
  18. Maurico Obstfeld, 2004. "External adjustment," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 140(4), pages 541-568, December.
  19. Philip R. Lane & G Milesi-Feretti, 2004. "Financial Globalization and Exchange Rates," CEP Discussion Papers dp0662, Centre for Economic Performance, LSE.
  20. Hnatkovska, Viktoria, 2010. "Home bias and high turnover: Dynamic portfolio choice with incomplete markets," Journal of International Economics, Elsevier, vol. 80(1), pages 113-128, January.
  21. Kollmann, Robert, 2006. "International Portfolio Equilibrium and the Current Account," CEPR Discussion Papers 5512, C.E.P.R. Discussion Papers.
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