A Dynamic Equilibrium Model of Imperfectly Integrated Financial Markets

Nicolas Coeurdacier and Stéphane Guibaud

No DR 06014, ESSEC Working Papers from ESSEC Research Center, ESSEC Business School

Abstract: The goal of this paper is to analyze the determination of countries equity portfolios and countries stock returns behavior in the context of imperfectly integrated financial markets. We build a continuous-time equilibrium model of a two-country endowment economy in which the level of financial integration is simply captured by with holding taxes on foreign dividends. Despite the heterogeneity among investors induced by these taxes, we obtain approximate closed-form expressions for asset prices and we characterize equity holdings and national assets returns behavior in equilibrium. The existence of a friction akin to a with holding tax on foreign dividends has two opposite effects on portfolios: the first mechanical effect is to reduce foreign holdings by reducing expected returns on foreign assets; but there is a second effect, which is to reduce endogenously the correlation between national asset returns, thus increasing the willingness to diversify internationally. Quantitatively, we show that the direct effect dwarfs the indirect effect and we find that, for a reasonably high level of substituability between national assets, small frictions on equity markets can generate a large home bias in portfolios. Empirically, our model is consistent with a broad range of findings on international financial integration. Moreover, we provide an explanation for the puzzling positive relationship that has been found in the data between bilateral equity holdings and bilateral stock returns correlations.

Keywords: Asset Pricing with Heterogeneous Investors; Financial Integration; Home Bias in Portfolio; International Stock Returns Correlations; Stochastic Pareto-Negishi Weight (search for similar items in EconPapers)
JEL-codes: F30 G11 G12 (search for similar items in EconPapers)
Pages: 48 pages
Date: 2006-10
References: Add references at CitEc
Citations: View citations in EconPapers (13)

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Related works:
Journal Article: A dynamic equilibrium model of imperfectly integrated financial markets (2014)
Working Paper: A Dynamic Equilibrium Model of Imperfectly Integrated Financial Markets (2014)
Working Paper: A Dynamic Equilibrium Model of Imperfectly Integrated Financial Markets (2014)
Working Paper: A dynamic equilibrium model of imperfectly integrated financial markets (2005)
Working Paper: A dynamic equilibrium model of imperfectly integrated financial markets (2005)
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