DP6647 The Role of Portfolio Constraints in the International Propagation of Shocks

Author(s): Anna Pavlova, Roberto Rigobon
Publication Date: January 2008
Keyword(s): asset pricing, contagion, International finance, portfolio constraints, terms of trade, wealth transfer
JEL(s): F31, F36, G12, G15
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6647

We study the comovement among stock prices and among exchange rates in a three-good three-country Centre-Periphery dynamic equilibrium model in which the Centre?s agents face portfolio constraints. We characterize equilibrium in closed form for a broad class of portfolio constraints, solving for stock prices, terms of trade, and portfolio holdings. We show that portfolio constraints generate wealth transfers between the Periphery countries and the Centre, which increase the comovement of the stock prices across the Periphery. We associate this excess comovement caused by portfolio constraints with the phenomenon known as contagion. The model generates predictions consistent with other important empirical results such as amplification and flight-to-quality effects.