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The International Diversification Puzzle when Goods Prices Are Sticky; It's Really About Exchange-Rate Hedging, not Equity Portfolios

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  • Akito Matsumoto
  • Charles Engel

Abstract

This paper develops a two-country monetary DSGE model in which households choose a portfolio of home and foreign equities, and a forward position in foreign exchange. Some nominal goods prices are sticky. Trade in these assets achieves the same allocations as trade in a complete set of nominal state-contingent claims in our linearized model. When there is a high degree of price stickiness, we show that not much equity diversification is required to replicate the complete-markets equilibrium when agents are able to hedge foreign exchange risk sufficiently. Moreover, temporarily sticky nominal goods prices can have large effects on equity portfolios even when dividend processes are very persistent.

Suggested Citation

  • 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.
  • Handle: RePEc:imf:imfwpa:09/12
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    References listed on IDEAS

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    Keywords

    Capital markets; Commodity prices; Asset management; Economic models; Private investment; Foreign exchange; international risk sharing; international portfolio allocation; exchange rate hedging; equity home bias; exchange rate; hedge; home currency; nominal exchange rate; Equity Home Bias International Risk Sharing;

    JEL classification:

    • E13 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Neoclassical
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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