International Diversification in Debt vs Equity

David Amdur

Working Papers from Georgetown University, Department of Economics

Abstract: Can a standard open economy macro model generate realistic international diversification in debt AND equity? We address this question by solving for steady-state portfolios in a two-country, two-good DSGE endowment model with consumption home bias. We compare two different asset trading regimes. In the first, households in each country trade equity claims on their underlying stochastic endowments; in the second, households trade locally-denominated bonds. We derive locally accurate closed-form solutions for steady-state portfolios under each regime. The model can predict realistic home equity bias and bond diversification if the intratemporal elasticity of substitution between home and foreign goods is sufficiently low. However, for commonly used parameter values, the standard two-good model understates bond diversification and overstates equity diversification. Classification-JEL Codes: F36, F41, G11

Keywords: Home bias; international diversification puzzle; portfolio choice; open economy macroeconomics; DSGE models (search for similar items in EconPapers)
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