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Portfolio Home Bias and External Habit Formation

  • Andreas Stathopoulos

    (University of Southern California)

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    This paper explores international portfolio choice in a multi-country, multi-good general equilibrium setting which features time-varying risk aversion generated by external habit formation. It is shown that time variation in conditional risk aversion generates time variation in the countries' relative consumption expenditure. As a result, financing equilibrium consumption entails hedging against adverse fluctuations in risk aversion. In equilibrium, an increase in home risk aversion tends to appreciate the home equity and depreciate the foreign equity, so each agent hedges by shifting her equity portfolio towards the home equity claim. Furthermore, the model is able to generate realistic asset price and exchange rate dynamics, satisfying a long-standing need of the general equilibrium literature in international finance.

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    File URL: https://www.economicdynamics.org/meetpapers/2012/paper_502.pdf
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    Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 502.

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    Date of creation: 2012
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    Handle: RePEc:red:sed012:502
    Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
    Fax: 1-314-444-8731
    Web page: http://www.EconomicDynamics.org/society.htm
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    1. Moore, Michael J. & Roche, Maurice J., 2010. "Solving exchange rate puzzles with neither sticky prices nor trade costs," Journal of International Money and Finance, Elsevier, vol. 29(6), pages 1151-1170, October.
    2. Bekaert, Geert & Engstrom, Eric & Xing, Yuhang, 2009. "Risk, uncertainty, and asset prices," Journal of Financial Economics, Elsevier, vol. 91(1), pages 59-82, January.
    3. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," International Trade 0012003, EconWPA.
    4. Coeurdacier, Nicolas & Kollmann, Robert Miguel W. K. & Martin, Philippe J., 2008. "International portfolios, capital accumulation and foreign assets dynamics," Discussion Paper Series 1: Economic Studies 2008,19, Deutsche Bundesbank, Research Centre.
    5. Adrien Verdelhan, 2006. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Computing in Economics and Finance 2006 217, Society for Computational Economics.
    6. Stockman, Alan C. & Dellas, Harris, 1989. "International portfolio nondiversification and exchange rate variability," Journal of International Economics, Elsevier, vol. 26(3-4), pages 271-289, May.
    7. Hanno Lustig & Adrien Verdelhan, 2007. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk," American Economic Review, American Economic Association, vol. 97(1), pages 89-117, March.
    8. Emmanuel Farhi & Xavier Gabaix, 2008. "Rare Disasters and Exchange Rates," NBER Working Papers 13805, National Bureau of Economic Research, Inc.
    9. Kollmann, Robert, 2006. "International Portfolio Equilibrium and the Current Account," CEPR Discussion Papers 5512, C.E.P.R. Discussion Papers.
    10. 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.
    11. Robert Kollmann, 2006. "A Dynamic Equilibrium Model of International Portfolio Holdings: Comment," Econometrica, Econometric Society, vol. 74(1), pages 269-273, 01.
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