Gravity in International Finance

The past decade has witnessed an explosion of papers estimating gravity equations for cross-border financial holdings. The aim of the paper is to develop a theoretical foundation for the empirical gravity literature applied to finance. The gravity specification is closely analogous to that developed for goods trade, even though it is based on a very different type of theory. We show how the theory can be used to estimate international financial frictions and conduct comparative statics analysis with respect to changes in these frictions. We use a dataset for cross-border equity holdings among 24 industrialized countries to illustrate these results.