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

  • Alexander Michaelides

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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Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 195.

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Date of creation: Dec 2003
Date of revision:
Publication status: Published in Journal of Economic Dynamics and Control, December, 2003, 28(3), pp. 555-594. ISSN: 0165-1889
Handle: RePEc:ehl:lserod:195
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