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A dynamic equilibrium of imperfectly integrated financial markets

  • Nicolas Coeurdacier
  • Stéphane Guibaud

    (London School of Economics and Political Science (LSE))

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.

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Paper provided by Sciences Po in its series Sciences Po publications with number info:hdl:2441/c8dmi8nm4pdjkuc9g81p80a37.

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Date of creation: Oct 2008
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Handle: RePEc:spo:wpmain:info:hdl:2441/c8dmi8nm4pdjkuc9g81p80a37
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