international diversification puzzle is not as bad as you think
By: Jonathan Heathcote, Fabrizio Perri.
Contributors: Perri, Fabrizio.; National Bureau of Economic Research.
Series: NBER working paper series -- no. 13483.; Working paper series (National Bureau of Economic Research) -- working paper no. 13483.
Publisher: National Bureau of Economic Research
Published: 2007
Place of publication: Cambridge, Mass
Language: eng
Number of pages: 43
Subjects: Investments, Foreign -- Econometric models; International trade -- Econometric models
Description: In simple one-good international macro models, the presence of non-diversifiable labor income risk means that country portfoliosshould be heavily biased toward foreign assets. The fact that theopposite pattern of diversification is observed empirically constitutes the international diversification puzzle. We embed aportfolio choice decision in a frictionless two-country, two-good version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, we derive a closed-form expression for equilibrium country portfolios. These are biased towards domestic assets, as in the data. Home bias arises because endogenous international relative price fluctuations make domestic stocks a good hedge against non-diversifiable labor income risk. We then use our our theory to link openness to trade to the level of diversification, and find that it offers a quantitatively compelling account for the patterns of international diversification observed across developed economies in recent years.
Notes: "October 2007"

Includes bibliographical references (p. 35-38).

Also available in PDF from the NBER world wide web site (www.nber.org).