DP3066 International Portfolio Choice: Liquidity Constraints and the Home Equity Bias Puzzle

Author(s): Alexander Michaelides
Publication Date: November 2001
Keyword(s): home equity bias, information costs, international portfolio choice, liquidity constraints
JEL(s): E20, G11
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3066

This Paper solves for optimal international portfolio choice in the presence of liquidity constraints and undiversifiable labour income risk. Optimal portfolios are internationally diversified while positive correlation between domestic stock market returns and permanent labour income shocks can worsen the home equity bias puzzle. 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.