International Risk Sharing and Portfolio Choice with Non-separable Preferences

This paper aims to account for the Backus-Smith puzzle in a generally calibrated two-country DSGE model with endogenous portfolio choice in international bonds and equities. There are multiple shocks, including shocks to TFP, labour supply, investment, government spending and monetary policy. Hence, there are more risks than can be spanned by international trade in equities and bonds, i.e. markets are incomplete. The utility function in the benchmark model is non-separable in consumption and leisure and there is external habit formation in consumption. We compare the benchmark model with models that differ according to preference/habit specification and financial market structure. We find that the benchmark model with non-separable preferences across consumption and leisure, habit formation and incomplete financial markets implies almost zero correlation between relative consumption and the real exchange rate while generating bond and equity portfolios that are broadly in line with the data. What is more, the cross-country correlation of consumption is lower than the cross-country correlation of output in our benchmark model, which has proved to be a difficult fact to match in IRBC models. Non-separable preferences are found to be crucial to generating these results but financial market structure plays only a minor role.