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The International Diversification Puzzle Is Not as Bad as You Think

  • Fabrizio Perri

    ()

    (Department of Economics, University of Minnesota)

  • Jonathan Heathcote

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, twogood 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 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.

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File URL: http://www.econ.umn.edu/merr/2007_3.pdf
File Function: First version, 2007
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Paper provided by University of Minnesota, Department of Economics in its series Working Papers with number 2007-3.

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Length: 44 pages
Date of creation: 08 Oct 2007
Date of revision: 08 Oct 2007
Handle: RePEc:min:wpaper:2007-3
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