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A Portfolio Theory of International Capital Flows

Michael Devereux () and Makoto Saito ()

No 5746, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Recent global imbalances and large gross external financial movements have raised interest in modeling the relationship between international financial market structure and capital flows. This paper constructs a model in which the composition of national portfolios is an essential element in facilitating international capital flows. Each country chooses an optimal portfolio in face of real and nominal risk. Current account deficits are financed by net capital flows which reflect differential movements in the holdings of gross external assets and liabilities. A country experiencing a current account deficit will be accumulating both gross external liabilities and gross external assets. Net capital flows generate movements in risk premiums such that the rate of return on a debtor country's gross liabilities is lower than the return on its gross assets. This ensures stability of the world wealth distribution. An attractive feature of the model is that portfolio shares, returns, and the wealth distribution can be characterized analytically. A calibrated version of the model can match quite well the observed measures of gross and net external assets and liabilities for the US economy.

Keywords: current account; international capital flows; portfolio (search for similar items in EconPapers)
JEL-codes: F32 F34 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-fin and nep-ifn
Date: 2006-07
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Working Paper: A Portfolio Theory of International Capital Flows (2006) Downloads
Working Paper: A Portfolio Theory of International Capital Flows (2006) Downloads
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