International portfolio choice, liquidity constraints and the home equity bias puzzle

Alexander Michaelides

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: This paper solves for optimal international portfolio choice in the presence of liquidity constraints and undiversifiable labor income risk. Optimal portfolios are internationally diversified while positive correlation between domestic stock market returns and permanent labor income shocks can generate a complete portfolio specialization in foreign stocks. Nevertheless, either small costs associated with investing abroad or a slightly positive domestic to foreign equity premium differential are sufficient to either deter households from participating in a foreign market or generate a substantial bias for home equities. The benefits of international diversification are limited because consumption fluctuations can be smoothed with a small amount of buffer stock saving, while exchange rate risk makes foreign investments less appealing to risk averse investors.

Keywords: international portfolio choice; home equity bias; liquidity constraints; information costs. JEL classification codes: E2; F39; G11 (search for similar items in EconPapers)
JEL-codes: E2 F39 G11 (search for similar items in EconPapers)
Date: 2003-12
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (23)

Published in Journal of Economic Dynamics and Control, December, 2003, 28(3), pp. 555-594. ISSN: 0165-1889

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http://eprints.lse.ac.uk/195/ Open access version. (application/pdf)

Related works:
Journal Article: International portfolio choice, liquidity constraints and the home equity bias puzzle (2003)
Working Paper: International Portfolio Choice: Liquidity Constraints and the Home Equity Bias Puzzle (2001)
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