Working Paper: CEPR ID: DP6870
Authors: Alejandro Cuat; Christian Fons-Rosen
Abstract: This paper presents a model of international portfolio choice based on the pattern of comparative advantage in goods trade. Countries have varying degrees of similarity in their factor endowment ratios, and are subject to aggregate productivity shocks. Risk averse consumers can insure against these shocks by investing their wealth at home and abroad. The change in relative prices after a positive shock in a particular country provides insurance to countries that have dissimilar factor endowment ratios, but is bad news for countries with similar factor endowment ratios, since their incomes will worsen. Therefore countries with similar comparative advantages have a stronger incentive to invest in one another for insurance purposes than countries with dissimilar comparative advantages. Empirical evidence linking bilateral international investment positions to a proxy for relative factor endowments supports our theory: the similarity of host and source countries in their relative capital-labor ratios has a positive effect on the source country's investment position in the host country. The effect of similarity is enhanced by the size of host countries as predicted by the theory.
Keywords: factor endowments; gravity equation; international portfolio choice
JEL Codes: F21; F34; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| similar capital-labor ratios (D29) | investment in each other (E22) |
| positive productivity shock in capital-abundant country (O49) | investment in similar endowment countries (O57) |
| size of host country (O57) | investment position (G11) |
| size of host country (O57) | effect on world prices (F69) |
| similarity of host and source countries in capital-labor ratios (F16) | source country's investment position in host country (F21) |