The International Diversification Puzzle is Not as Bad as You Think

Jonathan Heathcote and Fabrizio Perri

No 6982, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: In simple one-good international macro models, the presence of non-diversifiable labor income risk means that country portfolios should be heavily biased toward foreign assets. The fact that the opposite pattern of diversification is observed empirically constitutes the international diversification puzzle. We embed a portfolio 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 fully characterize equilibrium country portfolios. These are biased towards domestic assets, as in the data. Home bias arises because endogenous international relative price fluctuations make domestic assets a good hedge against non-diversifiable labor income risk. We then use 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.

Keywords: Country portfolios; Home bias; International business cycles (search for similar items in EconPapers)
JEL-codes: F36 F41 (search for similar items in EconPapers)
Date: 2008-10
New Economics Papers: this item is included in nep-cba, nep-dge and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (23)

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Related works:
Journal Article: The International Diversification Puzzle Is Not as Bad as You Think (2013)
Working Paper: The international diversification puzzle is not as bad as you think (2013)
Working Paper: The international diversification puzzle is not as bad as you think (2007)
Working Paper: The International Diversification Puzzle Is Not as Bad as You Think (2007)
Working Paper: The International Diversification Puzzle Is Not As Bad As You Think (2007)
Working Paper: The international diversification puzzle is not as bad as you think (2004)
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