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Return Volatility and International Portfolio Choice

  • Nicolas Coeurdacier

    (ESSEC and Paris School of Economics)

  • Robert Kollmann

    (ECARES, Free University of Brussels & CEPR)

  • Philippe Martin

    (University Paris I & CEPR)

Despite the liberalization of international capital flows during the last decades, typical investors continue to hold most of their wealth in domestic assets. International RBC models can explain that 'portfolio home bias', if consumption home bias is incorporated, i.e. the fact that the bulk of consumption consists of locally produced goods (Obstfeld (2006)). However RBC models fail to explain the high volatility of equity returns and real exchange rates, and predict excessive cross-country risk sharing. This paper develops a model that simultaneously generates realistic portfolio holdings and return volatilities, and imperfect risk pooling. In the structure here, there are supply shocks, aggregate demand shocks (variations in government purchases, taste shocks), and exogenous shocks to equity risk premia. There is trade in domestic and foreign stocks and bonds. Demand shocks and risk premium shocks generate realistic return volatility, and create a strong bias towards holding local equity. Intuitively, a country-specific demand increase raises the relative price of the locally produced good, if there is consumption home bias, and it thus raises the relative return on local equity; local equity thus has a high return, in states of the world in which the household wishes to consume a lot. By biasing their portfolios toward local equity, countries can also insulate their net foreign assets and consumption spending, from exogenous risk premium shocks. When taste shocks follow random walks, there are sunspot equilibria characterized by sizable departures from full risk sharing.

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Paper provided by Society for Economic Dynamics in its series 2007 Meeting Papers with number 474.

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Date of creation: 2007
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Handle: RePEc:red:sed007:474
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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  1. Robert Kollmann, 1996. "Incomplete asset markets and the cross-country consumption correlation puzzle," ULB Institutional Repository 2013/7640, ULB -- Universite Libre de Bruxelles.
  2. V. V Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Oxford University Press, vol. 69(3), pages 533-563.
  3. Fabrizio Perri & Jonathan Heathcote, 2007. "The International Diversification Puzzle Is Not as Bad as You Think," Working Papers 2007-3, University of Minnesota, Department of Economics, revised 08 Oct 2007.
  4. Heathcote, Jonathan & Perri, Fabrizio, 2004. "Financial globalization and real regionalization," Journal of Economic Theory, Elsevier, vol. 119(1), pages 207-243, November.
  5. Philippe Martin & Helene Rey, 2004. "Financial Super-Markets: Size Matters for Asset Trade," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00176904, HAL.
  6. Fabio Ghironi & Jaewoo Lee & Alessandro Rebucci, 2009. "The Valuation Channel of External Adjustment," Boston College Working Papers in Economics 722, Boston College Department of Economics.
  7. Philippe Martin & Hélène Rey, 2006. "Globalization and Emerging Markets: With or Without Crash?," Sciences Po publications info:hdl:2441/9261, Sciences Po.
  8. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," International Trade 0012003, EconWPA.
  9. Bottazzi, Laura & Pesenti, Paolo & van Wincoop, Eric, 1996. "Wages, profits and the international portfolio puzzle," European Economic Review, Elsevier, vol. 40(2), pages 219-254, February.
  10. Charles Engel & Akito Matsumoto, 2006. "Portfolio Choice in a Monetary Open-Economy DSGE Model," NBER Working Papers 12214, National Bureau of Economic Research, Inc.
  11. Nicolas Coeurdacier & Stéphane Guibaud, 2008. "A dynamic equilibrium of imperfectly integrated financial markets," Sciences Po publications info:hdl:2441/c8dmi8nm4pd, Sciences Po.
  12. 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.
  13. Pavlova, Anna & Rigobon, Roberto, 2004. "Asset Prices and Exchange Rates," Working papers 4322-03, Massachusetts Institute of Technology (MIT), Sloan School of Management.
  14. Ghironi, Fabio, 2006. "Macroeconomic interdependence under incomplete markets," Journal of International Economics, Elsevier, vol. 70(2), pages 428-450, December.
  15. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1998. "Can sticky price models generate volatile and persistent real exchange rates?," Staff Report 223, Federal Reserve Bank of Minneapolis.
  16. Kollmann, Robert, 2006. "International Portfolio Equilibrium and the Current Account," CEPR Discussion Papers 5512, C.E.P.R. Discussion Papers.
  17. Kollmann, Robert, 1995. "Consumption, real exchange rates and the structure of international asset markets," Journal of International Money and Finance, Elsevier, vol. 14(2), pages 191-211, April.
  18. Robert Kollmann, 2006. "A dynamic general equilibrium model of international portfolio holding: comment," ULB Institutional Repository 2013/7622, ULB -- Universite Libre de Bruxelles.
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