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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. Nicolas Coeurdacier & Stéphane Guibaud, 2005. "A dynamic equilibrium model of imperfectly integrated financial markets," PSE Working Papers halshs-00590775, HAL.
  2. Kollmann, R., 1992. "Consumption, Real Exchange Rates and the Structure of International Asset Markets," Cahiers de recherche 9232, Universite de Montreal, Departement de sciences economiques.
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  5. Ghironi, Fabio & Lee, Jaewoo & Rebucci, Alessandro, 2015. "The Valuation Channel of External Adjustment," CEPR Discussion Papers 10564, C.E.P.R. Discussion Papers.
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  7. Helene Rey & Philippe Martin, 2005. "Globalization and Emerging Markets: With or Without Crash?," 2005 Meeting Papers 152, Society for Economic Dynamics.
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  12. Kollmann, Robert, 1991. ""Essays on International Business Cycles", PhD thesis, Economics Department, University of Chicago, 1991," MPRA Paper 69905, University Library of Munich, Germany.
  13. 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.
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  19. 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.
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  21. Robert Kollmann, 1996. "Incomplete asset markets and the cross-country consumption correlation puzzle," ULB Institutional Repository 2013/7640, ULB -- Universite Libre de Bruxelles.
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