trade costs in goods market lead to home bias in equities?.

Two of the main puzzles in international economics are the consumption and the portfolio home biases. We solve for international equity portfolios in a two-country/two-good stochastic equilibrium model with trade costs in goods markets. We show that introducing trade costs, as suggested by Obstfeld and Rogoff [Obstfeld, M., Rogoff, K., 2000a. The Six Major Puzzles in International Macroeconomics: Is There a Common Cause? NBER Macroeconomics Annual, 15], is not sufficient to explain these two puzzles simultaneously. On the contrary, we find that trade costs create a foreign bias in portfolios for reasonable parameter values. This result is robust to the addition of non-tradable goods for standard calibrations of the preferences.Trade costs, Home bias, Portfolio choice, International macroeconomics;

Do Trade Costs in Goods Market Lead to Home Bias in Equities?

Two of the main puzzles in international economics are the consumption and the portfolio home biases. They are empirically related: countries that are more open to trade also have more internationally diversified portfolios. In a two-country stochastic equilibrium model, I prove that introducing trade costs in goods market alone, as suggested by Obstfeld and Rogoff [2000], is not sufficient to explain these two puzzles simultaneously. On the contrary, for reasonable parameter values, trade costs create a foreign bias in portfolios. To reconcile facts and theory, I introduce a combination of small frictions in financial markets and trade costs in goods market. The interaction between the two types of frictions determines optimal portfolio allocation. When trade costs increase, competition in the goods market softens and the volatility of domestic income falls. Facing lower risk, investors have less incentive to pay the financial transaction cost and increase their holdings of domestic assets. The model correctly predicts that the larger the home bias in consumption, the larger the home bias in portfolios.International Macroeconomics; Home Bias; Portfolio Choice; Trade Costs

International Portfolio Diversification Is Better Than You Think

Do investors completely ignore the basics of portfolio theory? Given their over-exposure on domestic risk, investors should try to hedge this risk by picking foreign assets that have low correlation with their home assets. In the data though, we find a robust positive relationship between bilateral equity holdings and bilateral return correlations. We argue that this finding could be driven by the common impact of financial integration on cross-border equity holdings and on cross-market correlations. Indeed, when we instrument current correlations with past correlations to control for endogeneity, we recover asset demand functions that decrease with returns correlation.Endogeneity Bias; Financial Integration; International Portfolio Choice; International Stock Return Correlations

Comment on 'External performance in low income countries' (by L. Christiansen, A. Prati, L. A. Ricci, S. Tokarick, and T. Tressel)

The paper investigates empirically the medium-term determinants of Current Accounts, Net Foreign Asset Positions and Real Exchange Rates in Low Income Countries (LICs). The authors build a new dataset for 54 LICs over the period 1981-2005. They control for the standard determinants of external balance (demography, fiscal stance, Net foreign assets, levels of development; see for instance Chinn and Prasad (2003)) among others and add some new potentially important variables for LICs such as external financing (Foreign Aid), policy distortions (quality of insititutions, capital account restrictions and domestic financial reforms) and the role of external shocks

The Geography of Asset Trade and the Euro: Insiders and Outsiders

This paper analyzes the determinants of cross-border asset trade on cross-country data and a Swedish data set. We focus our analysis on the impact of the euro for the determinants of bond trade, equity and banking assets. With the help of a theoretical model, we attempt to disentangle the different effects that the euro may have had on asset holdings for both euro zone countries and countries outside of the euro zone such as Sweden. We find evidence that the euro has implied 1) a unilateral financial liberalization which makes it cheaper for all countries to buy euro zone assets. For bonds and equity holdings, this would translate into approximately 14% and 17% decrease in transaction costs. Using Swedish data, we find that this effect of the euro is larger for flows than for stocks. 2) a preferential financial liberalization which on top of the previous effect has decreased transaction costs inside the euro zone by approximately 17% and 10% for bonds and equity respectively. 3) a diversion effect due to the fact that lower transaction costs inside the euro zone have led euro countries to purchase less equity from outside the euro zone. Our empirical analysis also suggests that the elasticity of substitution between bonds inside the euro zone is higher than between bonds denominated in different currencies. We illustrate this effect for transaction costs generated by the difference in the legal system.Euro; Gravity Equation; International Asset Trade

When bonds matter: home bias in goods and assets

Recent models of international equity portfolios exhibit two potential weaknesses: 1) the structure of equilibrium equity portfolios is determined by the correlation of equity returns with real exchange rates; yet empirically equities don't appear to be a good hedge against real exchange rate risk; 2) Equity portfolios are highly sensitive to preference parameters. This paper solves both problems. It first shows that in more general and realistic environments, the hedging of real exchange rate risks occurs through international bond holdings since relative bond returns are strongly correlated with real exchange rate fluctuations. Equilibrium equity positions are then optimally determined by the correlation of equity returns with the return on non-financial wealth, conditional on the bond returns. The model delivers equilibrium portfolios that are well-behaved as a function of the underlying preference parameters. We find reasonable empirical support for the theory for G-7 countries. We are able to explain short positions in domestic currency bonds for all G-7 countries, as well as significant levels of home equity bias for the US, Japan and Canada.

International equity holdings and stock returns correlations: Does diversification matter at all for portfolio choice?

Do investors completely ignore the basics of portfolio theory? Given their over-exposure on domestic risk, investors should try to hedge this risk by picking foreign assets that have low correlation with their home assets. In the data though, we find a robust positive relationship between bilateral equity holdings and bilateral return correlations. We argue that this finding could be driven by the common impact of "financial integration" on cross-border equity holdings and on cross-market correlations. Indeed, when we instrument current correlation with past correlation to control for endogeneity, we recover asset demand functions that decrease with return correlation.international portfolio choice ; international stock return correlations ; financial integration ; endogeneity bias

A Dynamic Equilibrium Model of Imperfectly Integrated Financial Markets

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.Asset Pricing with Heterogeneous Investors; Financial Integration; Home Bias in Portfolio; International Stock Returns Correlations; Stochastic Pareto-Negishi Weight

The Geography of Trade in Goods and Asset Holdings

Gravity models have been widely used to describe bilateral trade in goods. Recently, Portes and Rey [1999] applied this framework to cross border equity flows and found that distance, which proxies information asymmetries in financial markets, is a surprisingly very large barrier to cross-border asset trade. We adopt here a different point of view and explore the complementarity between bilateral trade in goods and bilateral asset holdings. We jointly study trade in goods and banking assets in a simultaneous gravity equations framework using different instruments for both endogenous variables. To instrument trade in goods, we choose geographical variables (excluding distance) and data on bilateral transport costs. For asset holdings, we use legal similarities between countries and data on the international taxation of withheld capital. We find that the strong correlation between bilateral trade in goods and asset holdings is not simply due to distance: bilateral trade in goods generates bilateral asset holdings and vice versa. Those effects are of first order magnitude: a 10% increase in trade generates a 6 to 7% increase of asset holdings, and a 10% increase in banking claims induces a 2 to 3% increase in trade. Finally, we investigate the question of the remaining impact of distance. We find out that the impact of distance on trade in goods is only slightly reduced, while for asset holdings, a large part of the effect of distance is going through trade.Gravity Models; International Finance; International Trade; Simultaneous Equations