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International Portfolio Allocation under Model Uncertainty

  • Pierpaolo Benigno
  • Salvatore Nisticò

This paper proposes an explanation of the international home bias in equity based on ambiguity aversion. Doubts imply an additional hedging motif driven by the interaction between real exchange rate risk and ambiguity aversion. What matters is the long-run as opposed to the short-run risk. Domestic equity is a good hedge with respect to long-run real exchange rate risk even when bonds are traded. The higher is the degree of ambiguity aversion, the stronger is the home bias. We identify the degree of ambiguity aversion with detection error probabilities and show that our framework is able to explain a large share of the observed US home bias, as well as other stylized facts on US cross-border asset holdings. Without doubts, a standard open-economy macroeconomic model would be unsuccessful along all these dimensions. An older version of this paper is available at http://www.nber.org/papers/w14734.rev0.pdf to NBER subscribers and those in domains eligible for free downloads. Individual purchasers of papers are directed to email orders@nber.org or to call 617 588-1405 to purchase the older version.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14734.

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Date of creation: Feb 2009
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Publication status: published as Pierpaolo Benigno & Salvatore Nistico, 2012. "International Portfolio Allocation under Model Uncertainty," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(1), pages 144-89, January.
Handle: RePEc:nbr:nberwo:14734
Note: AP IFM ME
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  1. Larry G. Epstein & JianJun Miao, 2001. "A Two-Person Dynamic Equilibrium under Ambiguity," RCER Working Papers 478, University of Rochester - Center for Economic Research (RCER).
  2. Lars Peter Hansen & Thomas J. Sargent, 2007. "Introduction to Robustness," Introductory Chapters, Princeton University Press.
  3. Nicolas Coeurdacier & Robert Kollmann & Philippe Martin, 2007. "International Portfolios with Supply, Demand and Redistributive Shocks," NBER Working Papers 13424, National Bureau of Economic Research, Inc.
  4. Jonathan Heathcote & Fabrizio Perri, 2004. "The international diversification puzzle is not as bad as you think," 2004 Meeting Papers 152, Society for Economic Dynamics.
  5. Giannis Vardas & Anastasios Xepapadeas, 2004. "Uncertainty Aversion and Robust Portfolio Choices," Working Papers 0408, University of Crete, Department of Economics.
  6. Strzalecki, Tomasz, 2011. "Axiomatic Foundations of Multiplier Preferences," Scholarly Articles 14397610, Harvard University Department of Economics.
  7. David K. Backus & Gregor W. Smith, 1993. "Consumption and Real Exchange Rates in Dynamic Economies with Non-Traded Goods," Working Papers 1252, Queen's University, Department of Economics.
  8. Kollmann, Robert, 2006. "International Portfolio Equilibrium and the Current Account," CEPR Discussion Papers 5512, C.E.P.R. Discussion Papers.
  9. David Backus & Bryan Routledge & Stanley Zin, 2004. "Exotic Preferences for Macroeconomists," NBER Working Papers 10597, National Bureau of Economic Research, Inc.
  10. Pavlova, Anna & Rigobon, Roberto, 2003. "Asset Prices and Exchange Rates," Working papers 4322-03, Massachusetts Institute of Technology (MIT), Sloan School of Management.
  11. 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.
  12. 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.
  13. repec:spo:wpecon:info:hdl:2441/c8dmi8nm4pdjkuc9g821o6lsg is not listed on IDEAS
  14. Robert J. Shiller, 1993. "Aggregate Income Risks and Hedging Mechanisms," Cowles Foundation Discussion Papers 1048, Cowles Foundation for Research in Economics, Yale University.
  15. Tomasz Strzalecki, 2013. "Temporal Resolution of Uncertainty and Recursive Models of Ambiguity Aversion," Econometrica, Econometric Society, vol. 81(3), pages 1039-1074, 05.
  16. Riccardo Colacito & Mariano M. Croce, 2011. "Risks for the Long Run and the Real Exchange Rate," Journal of Political Economy, University of Chicago Press, vol. 119(1), pages 153 - 181.
  17. 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.
  18. repec:spo:wpecon:info:hdl:2441/c8dmi8nm4pdjkuc9g708n2m4m is not listed on IDEAS
  19. David K. Backus & Federico Gavazzoni & Christopher Telmer & Stanley E. Zin, 2010. "Monetary Policy and the Uncovered Interest Parity Puzzle," NBER Working Papers 16218, National Bureau of Economic Research, Inc.
  20. Hansen, Lars Peter & Sargent, Thomas J., 2005. "Robust estimation and control under commitment," Journal of Economic Theory, Elsevier, vol. 124(2), pages 258-301, October.
  21. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," Sciences Po publications info:hdl:2441/8686, Sciences Po.
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