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Portfolio Choice and Partial Default in Emerging Markets: a quantitative analysis

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  • Kieran Walsh

    (Yale)

Abstract

What are the determinants and economic consequences of cross-border asset positions? I develop a new quantitative portfolio choice model and apply it to emerging market international finance. The model allows for partial default and accommodates trade in a rich set of assets. The latter means I am able to draw distinctions both between debt and equity finance and between gross and net debt. The main contribution is in developing portfolio choice techniques to analyze capital flows and default in an international finance context. I calibrate the pricing kernel of the model to match properties of U.S. stock returns and yield curves. I then analyze optimal emerging market portfolio and default behavior in response to realistic international financial fluctuations. My calibrated model jointly captures four empirical regularities that have been difficult to produce in the quantitative international finance literature: (1) Gross capital inflow and outflow are pro-cyclical. My model generates this as well as pro-cyclicality in equity liabilities and short-term debt. This is important because recent empirical work emphasizes that the level and composition of gross capital flows are at least as important as current accounts in understanding risk and predicting crises. (2) Most external defaults are partial. (3) Levels of gross external debt in excess of 50% of GNI are common. (4) Usually, borrowers default in bad economic times. Additionally, I provide novel characterizations for stochastic, infinite horizon portfolio problems with partial default. These results allow me to rapidly compute the consumption/portfolio problem solution, even with many assets and default, and they yield two key propositions: (i) for any degree of growth persistence, default increases as market conditions deteriorate, consistent with Regularity (4), and (ii) debt increases with the maturity length of bonds.

Suggested Citation

  • Kieran Walsh, 2014. "Portfolio Choice and Partial Default in Emerging Markets: a quantitative analysis," 2014 Meeting Papers 789, Society for Economic Dynamics.
  • Handle: RePEc:red:sed014:789
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    References listed on IDEAS

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    Cited by:

    1. Alexis Akira Toda, 2015. "Asset Prices and Efficiency in a Krebs Economy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 18(4), pages 957-978, October.
    2. Toda, Alexis Akira, 2014. "Incomplete market dynamics and cross-sectional distributions," Journal of Economic Theory, Elsevier, vol. 154(C), pages 310-348.

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