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

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

A dynamic equilibrium model of imperfectly integrated financial markets

We build a continous-time general equilibrium model of a two-country, pure-exchange economy featuring taxes on the repatriation of dividends. We find approximate closed-form expressions for asset prices, returns joint dynamics and equity portfolios, thus giving a full description of equilibrium in-between the polar cases of perfect integration and full segmentation. We show that large home bias in portfolios can result from small frictions on international financial markets. The reason is that, partly due to portfolio rebalancing, the international correlation of returns is very high - making assets close substitutes and implying that slight frictions have a dramatic effect on portfolio composition.asset pricing ; financial integration ; home bias in portfolio ; international stock returns correlations ; asymmetric taxation ; investors heterogeneity ; stochastic pareto-negishi weight

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.Etant donné leur surexposition au risque domestique, les investisseurs internationaux devraient essayer de couvrir ce risque en choisissant parmi les actifs étrangers ceux qui sont peu corrélés à leurs actifs domestiques. Dans les données néanmoins, nous trouvons une relation positive et robuste entre les détentions bilatérales d'actions et les corrélations bilatérales des rendements boursiers. Est-ce à dire que les investisseurs ignorent complètement les principes de base de la théorie du choix de portefeuille ? Selon nous, la relation positive que nous documentons provient de l'impact simultané du degré (bilatéral) d'intégration financière sur les portefeuilles et sur les co-mouvements des rendements. Lorsque nous instrumentons les corrélations contemporaines par les corrélations passées pour contrôler pour ce problème d'endogénéité, nous trouvons que - toutes choses égales par ailleurs - la demande pour un actif étranger est bien décroissante de sa corrélation avec l'indice domestique

A dynamic equilibrium model of imperfectly integrated financial markets

We build a continous-time general equilibrium model of a two-country, pure-exchange economy featuring taxes on the repatriation of dividends. We find approximate closed-form expressions for asset prices, returns joint dynamics and equity portfolios, thus giving a full description of equilibrium in-between the polar cases of perfect integration and full segmentation. We show that large home bias in portfolios can result from small frictions on international financial markets. The reason is that, partly due to portfolio rebalancing, the international correlation of returns is very high - making assets close substitutes and implying that slight frictions have a dramatic effect on portfolio composition.Nous proposons un modèle dynamique d'équilibre général d'une économie d'échanges à deux pays en présence de taxes au rapatriement des dividendes étrangers. Nous trouvons des approximations des formes analytiques pour les prix des actifs, la dynamique jointe des rendements boursiers et les portefeuilles de titres. Nous donnons ainsi une description complète de l'équilibre entre les deux cas polaires de parfaite intégration et d'autarcie financière. Nous montrons que les portefeuilles peuvent être fortement biaisés vers les actifs domestiques alors même que les frictions sur les marchés financiers internationaux sont faibles. En effet, un niveau élevé de la corrélation d'équilibre des rendements boursiers entre les deux pays, due en partie à des effets de "rebalancement" de portefeuille, rend les actifs très substituables et amplifie l'effet des frictions sur la composition du portefeuille

Fertility, Longevity and International Capital Flows

The neoclassical growth model predicts large capital flows towards fast-growing emerging countries. We show that incorporating fertility and longevity into a lifecycle model of savings changes the standard predictions when countries differ in their ability to borrow inter-temporally and across generations through social security. In this environment, global aging triggers capital flows from emerging to developed countries, and countries’ current account positions respond to growth adjusted by current and expected demographic composition. Data on international capital flows are broadly supportive of the theory. The fact that fast-growing emerging countries are also aging faster, while having less developed credit markets and pension systems, explains why they are more likely to export capital. Our quantitative multi-country overlapping generations model explains a significant fraction of the patterns of capital flows, across time and across developed and emerging countries

Credit constraints and growth in a global economy

We show that in an open-economy OLG model, the interaction between growth differentials and household credit constraints—more severe in fast-growing countries— can explain three prominent global trends: a divergence in private saving rates between advanced and emerging economies, large net capital outflows from the latter, and a sustained decline in the world interest rate. Micro-level evidence on the evolution of age-saving profiles in the U.S. and China corroborates our mechanism. Quantitatively, our model explains about a third of the divergence in aggregate saving rates, and a significant portion of the variations in age-saving profiles across countries and over time

Bond market clienteles, the yield curve and the optimal maturity structure of government debt

We propose a clientele-based model of the yield curve and optimal maturity structure of government debt. Clienteles are generations of agents at different life cycle stages in an overlapping- generations economy. An optimal maturity structure exists in the absence of distortionary taxes and induces efficient intergenerational risksharing. If agents are more risk-averse than log, then an increase in the long-horizon clientele raises the price and optimal supply of long-term bonds. But while a welfare-maximizing government caters to clienteles, it does not accommodate fully their demand, and limits issuance of long-term bonds to a level where these earn negative expected excess returns

Fertility policies and social security reforms in China

This paper analyzes the impact of relaxing fertility controls and expanding social security in China. We develop an overlapping generations model in which fertility decisions and capital accumulation are endogenously determined in the presence of social security. In our model, children are an alternative savings technology—as they transfer resources to their retired parents. Important feedback links arise between fertility and social security variables: an expansion of social security benefits reduces fertility—partially offsetting the effects of relaxing the one-child policy. The feedback loop between social security variables and fertility suggests that abandoning fertility restrictions may not be as effective in helping to finance China’s intended pension reform, especially if children are an important source of old-age support. The sustainability of the pension system is particularly at risk in the event of a growth slowdown. The objective of pension reforms may also be incongruent with other reforms, such as financial liberalization and financial integration