Working Paper: CEPR ID: DP3066
Authors: Alex Michaelides
Abstract: 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.
Keywords: home equity bias; information costs; international portfolio choice; liquidity constraints
JEL Codes: E20; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal portfolios are internationally diversified (G15) | portfolio performance (G11) |
| domestic stock market returns + labor income shocks (J49) | home equity bias (G51) |
| costs (J30) | barrier to diversification (L15) |
| domestic to foreign equity premium differential (F21) | home equities bias (G51) |