IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Log in (now much improved!) to save this paper

The international diversification puzzle is not as bad as you think

Listed author(s):
  • Jonathan Heathcote
  • Fabrizio Perri

In simple one-good international macro models, the presence of non-diversifiable labor income risk means that country portfolios should be heavily biased toward foreign assets. The fact that the opposite pattern of diversification is observed empirically constitutes the international diversification puzzle. We embed a portfolio choice decision in a frictionless two-country, two-good version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, we derive a closed-form expression for equilibrium country portfolios. These are biased towards domestic assets, as in the data. Home bias arises because endogenous international relative price fluctuations make domestic stocks a good hedge against non-diversifiable labor income risk. We then use our theory to link openness to trade to the level of diversification, and find that it offers a quantitatively compelling account for the patterns of international diversification observed across developed economies in recent years.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.minneapolisfed.org/research/common/pub_detail.cfm?pb_autonum_id=1103
Download Restriction: no

File URL: http://www.minneapolisfed.org/research/SR/SR398.pdf
Download Restriction: no

Paper provided by Federal Reserve Bank of Minneapolis in its series Staff Report with number 398.

as
in new window

Length:
Date of creation: 2007
Handle: RePEc:fip:fedmsr:398
Contact details of provider: Postal:
90 Hennepin Avenue, P.O. Box 291, Minneapolis, MN 55480-0291

Phone: (612) 204-5000
Web page: http://minneapolisfed.org/

More information through EDIRC

Order Information: Web: http://www.minneapolisfed.org/pubs/

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as
in new window

  1. David Backus & Patrick J. Kehoe & Finn E. Kydland, 1993. "International Business Cycles: Theory and Evidence," NBER Working Papers 4493, National Bureau of Economic Research, Inc.
  2. Philip R. Lane & Gian Maria Milesi-Ferretti, 2006. "The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities,1970–2004," The Institute for International Integration Studies Discussion Paper Series iiisdp126, IIIS.
  3. Jonathan Heathcote & Fabrizio Perri, 2007. "The international diversification puzzle is not as bad as you think," Staff Report 398, Federal Reserve Bank of Minneapolis.
  4. repec:spo:wpecon:info:hdl:2441/c8dmi8nm4pdjkuc9g7084aa4m is not listed on IDEAS
  5. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," NBER Technical Working Papers 0282, National Bureau of Economic Research, Inc.
  6. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1991. "International real business cycles," Staff Report 146, Federal Reserve Bank of Minneapolis.
  7. Bong-Chan Kho & René M. Stulz & Francis E. Warnock, 2006. "Financial Globalization, Governance, and the Evolution of the Home Bias," NBER Working Papers 12389, National Bureau of Economic Research, Inc.
  8. Richard Portes & Helene Rey, 1999. "The Determinants of Cross-Border Equity Flows," NBER Working Papers 7336, National Bureau of Economic Research, Inc.
  9. Martin D. D. Evans (Georgetown University) and Viktoria Hnatkovska (Georgetown University), 2005. "Solving General Equilibrium Models with Incomplete Markets and Many Assets," Working Papers gueconwpa~05-05-18, Georgetown University, Department of Economics.
  10. Bottazzi, Laura & Pesenti, Paolo & van Wincoop, Eric, 1996. "Wages, profits and the international portfolio puzzle," European Economic Review, Elsevier, vol. 40(2), pages 219-254, February.
  11. Akito Matsumoto & Charles Engel, 2009. "The International Diversification Puzzle when Goods Prices Are Sticky; It's Really About Exchange-Rate Hedging, not Equity Portfolios," IMF Working Papers 09/12, International Monetary Fund.
  12. Tille, Cédric & van Wincoop, Eric, 2010. "International capital flows," Journal of International Economics, Elsevier, vol. 80(2), pages 157-175, March.
  13. Laura Veldkamp & Stijn Van Nieuwerburgh, 2004. "Information Immobility and the Home Bias Puzzle," Working Papers 04-32, New York University, Leonard N. Stern School of Business, Department of Economics.
  14. Amir Amadi & Paul Bergin, 2006. "Understanding International Portfolio Diversification and Turnover Rates," NBER Working Papers 12473, National Bureau of Economic Research, Inc.
  15. Heathcote, J. & Perri, F., 2001. "Financial Globalization and Real Regionalization," New York University, Leonard N. Stern School Finance Department Working Paper Seires 01-11, New York University, Leonard N. Stern School of Business-.
  16. Anna Pavlova & Roberto Rigobon, 2007. "Asset Prices and Exchange Rates," Review of Financial Studies, Society for Financial Studies, vol. 20(4), pages 1139-1180.
  17. Heathcote, Jonathan & Perri, Fabrizio, 2002. "Financial autarky and international business cycles," Journal of Monetary Economics, Elsevier, vol. 49(3), pages 601-627, April.
  18. Nicolas Coeurdacier & Robert Kollmann & Philippe Martin, 2010. "International portfolios, capital accumulation and foreign assets dynamics," Sciences Po publications info:hdl:2441/c8dmi8nm4pd, Sciences Po.
  19. David Backus & Patrick J. Kehoe & Finn E. Kydland, 1992. "Dynamics of the Trade Balance and the Terms of Trade: The S-Curve," NBER Working Papers 4242, National Bureau of Economic Research, Inc.
  20. Ben S. Bernanke & Kenneth Rogoff, 2002. "Editorial in "NBER Macroeconomics Annual 2001, Volume 16"," NBER Chapters, in: NBER Macroeconomics Annual 2001, Volume 16, pages 1-6 National Bureau of Economic Research, Inc.
  21. Coeurdacier, Nicolas & Guibaud, Stéphane, 2006. "A Dynamic Equilibrium Model of Imperfectly Integrated Financial Markets," ESSEC Working Papers DR 06014, ESSEC Research Center, ESSEC Business School.
  22. Brainard, William & Tobin, James, 1991. "On the Internationalization of Portfolios," Discussion Papers 389, The Research Institute of the Finnish Economy.
  23. Devereux, Michael B & Sutherland, Alan, 2007. "Country Portfolio Dynamics," CEPR Discussion Papers 6208, C.E.P.R. Discussion Papers.
  24. Alan C. Stockman & Linda L. Tesar, 1991. "Tastes and technology in a two-country model of the business cycle: explaining international co-movements," Working Paper 9019, Federal Reserve Bank of Cleveland.
  25. Michaelides, Alexander, 2001. "International Portfolio Choice: Liquidity Constraints and the Home Equity Bias Puzzle," CEPR Discussion Papers 3066, C.E.P.R. Discussion Papers.
  26. Christian Julliard, 2004. "Human capital and international portfolio choice," LSE Research Online Documents on Economics 4813, London School of Economics and Political Science, LSE Library.
  27. Giancarlo Corsetti & Luca Dedola & Sylvain Leduc, 2008. "Productivity, External Balance, and Exchange Rates: Evidence on the Transmission Mechanism among G7 Countries," NBER Chapters, in: NBER International Seminar on Macroeconomics 2006, pages 117-194 National Bureau of Economic Research, Inc.
  28. Nicolas Coeurdacier, 2006. "Do trade costs in goods market lead to home bias in equities?," 2006 Meeting Papers 111, Society for Economic Dynamics.
  29. Douglas Gollin, 2002. "Getting Income Shares Right," Journal of Political Economy, University of Chicago Press, vol. 110(2), pages 458-474, April.
  30. Daron Acemoglu & Jaume Ventura, 2002. "The World Income Distribution," The Quarterly Journal of Economics, Oxford University Press, vol. 117(2), pages 659-694.
  31. Gomme, Paul & Klein, Paul, 2011. "Second-order approximation of dynamic models without the use of tensors," Journal of Economic Dynamics and Control, Elsevier, vol. 35(4), pages 604-615, April.
  32. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 3-24, August.
  33. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  34. Ignacio Palacios-Huerta, 2001. "The Human Capital of Stockholders and the International Diversification Puzzle," Working Papers 2001-12, Brown University, Department of Economics.
  35. Tesar, Linda L., 1993. "International risk-sharing and non-traded goods," Journal of International Economics, Elsevier, vol. 35(1-2), pages 69-89, August.
  36. Baxter, M. & Jermann, U.J., 1993. "The International Diversification Puzzle is Worse than you Think," RCER Working Papers 350, University of Rochester - Center for Economic Research (RCER).
  37. Ben S. Bernanke & Refet S. Gurkaynak, 2001. "Is Growth Exogenous? Taking Mankiw, Romer and Weil Seriously," NBER Working Papers 8365, National Bureau of Economic Research, Inc.
  38. Ben S. Bernanke & Kenneth S. Rogoff (ed.), 2002. "NBER Macroeconomics Annual 2001," MIT Press Books, The MIT Press, edition 1, volume 1, number 026252323x, December.
  39. Susanto Basu & John Fernald & Miles Kimball, 2004. "Are Technology Improvements Contractionary?," NBER Working Papers 10592, National Bureau of Economic Research, Inc.
  40. Maurice Obstfeld & Kenneth Rogoff, 2000. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," NBER Working Papers 7777, National Bureau of Economic Research, Inc.
  41. Cole, Harold, 1988. "Financial Structure and International Trade," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 29(2), pages 237-259, May.
  42. Lewis, Karen K, 1996. "What Can Explain the Apparent Lack of International Consumption Risk Sharing?," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 267-297, April.
  43. Uppal, Raman, 1993. " A General Equilibrium Model of International Portfolio Choice," Journal of Finance, American Finance Association, vol. 48(2), pages 529-553, June.
  44. Peter M. Demarzo & Ron Kaniel & Ilan Kremer, 2004. "Diversification as a Public Good: Community Effects in Portfolio Choice," Journal of Finance, American Finance Association, vol. 59(4), pages 1677-1716, 08.
  45. Michael B. Devereux & Alan Sutherland, 2011. "Country Portfolios In Open Economy Macro‐Models," Journal of the European Economic Association, European Economic Association, vol. 9(2), pages 337-369, 04.
  46. Aviat, Antonin & Coeurdacier, Nicolas, 2006. "The Geography of Trade in Goods and Asset Holdings," ESSEC Working Papers DR 06012, ESSEC Research Center, ESSEC Business School.
  47. David K. Backus & Gregor W. Smith, 1992. "Consumption and Real Exchange Rates in Dynamic Exchange Economies with Nontraded Goods," Working Papers 92-7, New York University, Leonard N. Stern School of Business, Department of Economics.
  48. Robert C. Feenstra & Philip A. Luck & Maurice Obstfeld & Katheryn N. Russ, 2014. "In Search of the Armington Elasticity," NBER Working Papers 20063, National Bureau of Economic Research, Inc.
  49. Christian Julliard, 2002. "The international diversification puzzle is not worse than you think," LSE Research Online Documents on Economics 4814, London School of Economics and Political Science, LSE Library.
  50. Aart Kraay & Norman Loayza & Luis Serven & Jaume Ventura, 2000. "Country Portfolios," NBER Working Papers 7795, National Bureau of Economic Research, Inc.
  51. Devereux, Michael B & Sutherland, Alan, 2006. "Solving for Country Portfolios in Open Economy Macro Models," CEPR Discussion Papers 5966, C.E.P.R. Discussion Papers.
  52. Stockman, Alan C. & Dellas, Harris, 1989. "International portfolio nondiversification and exchange rate variability," Journal of International Economics, Elsevier, vol. 26(3-4), pages 271-289, May.
  53. Beck, Thorsten & Demirguc-Kunt, Asli & Levine, Ross, 1999. "A new database on financial development and structure," Policy Research Working Paper Series 2146, The World Bank.
  54. 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.
  55. Juan Carlos Hatchondo, 2005. "Asymmetric information and the lack of international portfolio diversification," Working Paper 05-07, Federal Reserve Bank of Richmond.
  56. Karen K. Lewis, 1999. "Trying to Explain Home Bias in Equities and Consumption," Journal of Economic Literature, American Economic Association, vol. 37(2), pages 571-608, June.
  57. Ben S. Bernanke & Kenneth Rogoff, 2002. "NBER Macroeconomics Annual 2001, Volume 16," NBER Books, National Bureau of Economic Research, Inc, number bern02-1.
  58. Gehrig, Thomas, 1993. " An Information Based Explanation of the Domestic Bias in International Equity Investment," Scandinavian Journal of Economics, Wiley Blackwell, vol. 95(1), pages 97-109.
  59. Karsten Jeske, 2001. "Equity home bias: Can information cost explain the puzzle?," Economic Review, Federal Reserve Bank of Atlanta, issue Q3, pages 31-42.
  60. Akito Matsumoto & Charles Engel, 2005. "Portfolio Choice in a Monetary Open-Economy DSGE Model," IMF Working Papers 05/165, International Monetary Fund.
  61. Kollmann, Robert, 2006. "International Portfolio Equilibrium and the Current Account," CEPR Discussion Papers 5512, C.E.P.R. Discussion Papers.
  62. Baxter, Marianne & Jermann, Urban J. & King, Robert G., 1998. "Nontraded goods, nontraded factors, and international non-diversification," Journal of International Economics, Elsevier, vol. 44(2), pages 211-229, April.
  63. Pesenti, Paolo & van Wincoop, Eric, 2002. "Can Nontradables Generate Substantial Home Bias?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(1), pages 25-50, February.
  64. Cantor, Richard & Mark, Nelson C, 1988. "The International Transmission of Real Business Cycles," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 29(3), pages 493-507, August.
  65. Eric van Wincoop & Francis E. Warnock, 2006. "Is Home Bias in Assets Related to Home Bias in Goods?," NBER Working Papers 12728, National Bureau of Economic Research, Inc.
Full references (including those not matched with items on IDEAS)

This item is featured on the following reading lists or Wikipedia pages:

  1. The International Diversification Puzzle Is Not as Bad as You Think (JPE 2013) in ReplicationWiki

When requesting a correction, please mention this item's handle: RePEc:fip:fedmsr:398. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Jannelle Ruswick)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.