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A dynamic equilibrium of imperfectly integrated financial markets

Author

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  • Nicolas Coeurdacier
  • Stéphane Guibaud

    (London School of Economics and Political Science)

Abstract

This paper analyzes the determination of equity portfolios and country stock returns in the context of imperfectly integrated stock markets. We consider a continuous-time model of a two-country endowment economy in which the level of financial integration is captured by a proportional tax on foreign dividends. Despite the heterogeneity among investors induced by this tax, we obtain approximate closed-form expressions for asset prices and we characterize equity holdings and the joint process followed by country stock returns in equilibrium. Our model is consistent with a broad range of empirical findings on international financial integration. When the (endogenous) cross-country return correlation is high, small frictions in equity markets can generate a substantial home bias in portfolios. In the baseline version of our model, the cross- country return correlation is driven by fundamental correlation and portfolio rebalancing. In a two-good extension of the model, the adjustment of relative good prices can generate high stock return correlation even for a low level of fundamental correlation, thus magnifying the impact of the financial friction on portfolios.

Suggested Citation

  • Nicolas Coeurdacier & Stéphane Guibaud, 2008. "A dynamic equilibrium of imperfectly integrated financial markets," Sciences Po publications info:hdl:2441/c8dmi8nm4pd, Sciences Po.
  • Handle: RePEc:spo:wpmain:info:hdl:2441/c8dmi8nm4pdjkuc9g81p80a37
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    References listed on IDEAS

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    8. Rene M. Stulz, 1999. "Globalization of Equity Markets and the Cost of Capital," NBER Working Papers 7021, National Bureau of Economic Research, Inc.
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    Citations

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    Cited by:

    1. Tille, Cédric & van Wincoop, Eric, 2010. "International capital flows," Journal of International Economics, Elsevier, vol. 80(2), pages 157-175, March.
    2. Nicolas Coeurdacier & Hélène Rey, 2013. "Home Bias in Open Economy Financial Macroeconomics," Journal of Economic Literature, American Economic Association, vol. 51(1), pages 63-115, March.
    3. Philippe Bacchetta & Eric Van Wincoop, 2017. "Gradual Portfolio Adjustment: Implications for Global Equity Portfolios and Returns," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 17.05, Université de Lausanne, Faculté des HEC, DEEP.
    4. Nicolas Coeurdacier, 2012. "The international taxation of capital," 2012 Meeting Papers 440, Society for Economic Dynamics.

    More about this item

    Keywords

    Two Trees; Asset Pricing with Heterogenous Investors; Home Bias in Portfolios; International Stock Return Correlations; Financial Integration;

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration

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