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Relative factor endowments and international portfolio choice

  • Alejandro Cunat
  • Christian Fons-Rosen

This paper presents a model of international portfolio choice based on the pattern of comparative advantage in goods trade. Countries have varying degrees of similarity in their factor endowment ratios, and are subject to aggregate productivity shocks. Risk averse consumers can insure against these shocks by investing their wealth at home and abroad. The change in relative prices after a positive shock in a particular country provides insurance to countries that have dissimilar factor endowment ratios, but is bad news for countries with similar factor endowment ratios, since their incomes will worsen. Therefore countries with similar comparative advantages have a stronger incentive to invest in one another for insurance purposes than countries with dissimilar comparative advantages. Empirical evidence linking bilateral international investment positions to a proxy for relative factor endowments supports our theory: the similarity of host and source countries in their relative capital-labor ratios has a positive effect on the source country’s investment position in the host country. The effect of similarity is enhanced by the size of host countries as predicted by the theory.

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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 19562.

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Length: 36 pages
Date of creation: Jul 2008
Date of revision:
Handle: RePEc:ehl:lserod:19562
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