DP6982 The International Diversification Puzzle is Not as Bad as You Think
|Author(s):||Jonathan Heathcote, Fabrizio Perri|
|Publication Date:||October 2008|
|Keyword(s):||Country portfolios, Home bias, International business cycles|
|Programme Areas:||International Macroeconomics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=6982|
In simple one-good international macro models, the presence of non-diversifiable labor income risk means that country portfolios should be heavily biased toward foreign assets. The fact that the opposite pattern of diversification is observed empirically constitutes the international diversification puzzle. We embed a portfolio choice decision in a frictionless two-country, two-good version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, we fully characterize equilibrium country portfolios. These are biased towards domestic assets, as in the data. Home bias arises because endogenous international relative price fluctuations make domestic assets a good hedge against non-diversifiable labor income risk. We then use our theory to link openness to trade to the level of diversification, and find that it offers a quantitatively compelling account for the patterns of international diversification observed across developed economies in recent years.