Asset Liquidity and International Portfolio Choice
We study optimal asset portfolio choice in a two-country search-theoretic model of monetary exchange. We allow assets to not only represent claims on future consumption, but to also serve as means of payment. Assuming foreign assets trade at a cost, we characterize equilibria in which different countries’ assets arise as media of exchange in different types of trades. More frequent trading opportunities at home result in agents holding proportionately more domestic over foreign assets. Consequently, agents have larger claims to domestic over foreign consumption goods. Moreover, foreign assets turn over faster than home assets because the former have desirable liquidity properties, but unfavorable returns over time. Our mechanism offers an answer to a long-standing puzzle in international finance: a positive relationship between consumption and asset home bias, coupled with higher turnover rates of foreign over domestic assets.
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