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The international diversification puzzle is not as bad as you think

  • Jonathan Heathcote
  • Fabrizio Perri

In one-good international macro models with nondiversifiable labor income risk, country portfolios are heavily biased toward foreign assets. The fact that the opposite pattern of diversification is observed empirically constitutes the international diversification puzzle. This paper embeds a portfolio choice decision in a two-country, two-good version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, equilibrium country portfolios can be characterized in closed form. Portfolios are biased toward domestic assets, as in the data. Home bias arises because endogenous international relative price uctuations make domestic assets a good hedge against labor income risk. Evidence from developed economies in recent years is qualitatively and quantitatively consistent with the mechanisms highlighted by the theory. keywords: Country portfolios, International business cycles, Home bias jel classification codes : F36, F41

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 472.

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Date of creation: 2013
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Handle: RePEc:igi:igierp:472
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