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A dynamic equilibrium model of imperfectly integrated financial markets

Harjoat Bhamra, Nicolas Coeurdacier and Stéphane Guibaud

Journal of Economic Theory, 2014, vol. 154, issue C, 490-542

Abstract: This paper analyzes the determination of global equity portfolios and stock returns in the context of imperfectly integrated stock markets. We consider a continuous-time, two-country endowment economy, where the level of financial integration is captured by a proportional tax on foreign dividends. Despite the investor heterogeneity induced by this tax, we obtain approximate closed-form expressions for asset prices, and characterize equity holdings and the joint process followed by country-level stock returns in equilibrium. Our model is consistent with a broad range of empirical findings on international financial integration. When the (endogenous) cross-country return correlation is high, small frictions in equity markets can generate a substantial home bias in portfolios. In the baseline version of our model, the cross-country return correlation is driven by the fundamental correlation and portfolio rebalancing. In a two-good extension of the model, the adjustment of relative good prices can generate a high stock return correlation even for a low level of fundamental correlation, magnifying the impact of the financial friction on portfolios. We assess the quantitative performance of the model in a calibration exercise using data from G7 countries.

Keywords: Two trees; Asset pricing with heterogeneous investors; Home bias in portfolios; International stock return correlations; Financial integration (search for similar items in EconPapers)
JEL-codes: F30 G11 G12 G15 (search for similar items in EconPapers)
Date: 2014
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Working Paper: A Dynamic Equilibrium Model of Imperfectly Integrated Financial Markets (2006) Downloads
Working Paper: A dynamic equilibrium model of imperfectly integrated financial markets (2005) Downloads
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DOI: 10.1016/j.jet.2014.09.011

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