International Portfolio Allocation under Model Uncertainty

Pierpaolo Benigno and Salvatore Nisticò

No 14734, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper proposes an explanation of the international home bias in equity based on ambiguity aversion. Doubts imply an additional hedging motif driven by the interaction between real exchange rate risk and ambiguity aversion. What matters is the long-run as opposed to the short-run risk. Domestic equity is a good hedge with respect to long-run real exchange rate risk even when bonds are traded. The higher is the degree of ambiguity aversion, the stronger is the home bias. We identify the degree of ambiguity aversion with detection error probabilities and show that our framework is able to explain a large share of the observed US home bias, as well as other stylized facts on US cross-border asset holdings. Without doubts, a standard open-economy macroeconomic model would be unsuccessful along all these dimensions.

JEL-codes: F3 G11 G15 (search for similar items in EconPapers)
Date: 2009-02
New Economics Papers: this item is included in nep-cba, nep-dge, nep-opm and nep-upt
Note: AP IFM ME
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Citations: View citations in EconPapers (31)

Published as Pierpaolo Benigno & Salvatore Nistico, 2012. "International Portfolio Allocation under Model Uncertainty," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(1), pages 144-89, January.

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