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International portfolio choice, liquidity constraints and the home equity bias puzzle

Michaelides, Alexander (2003) International portfolio choice, liquidity constraints and the home equity bias puzzle. Journal of Economic Dynamics and Control, 28 (3). pp. 555-594. ISSN 0165-1889

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Abstract

This paper solves for optimal international portfolio choice in the presence of liquidity constraints and undiversifiable labor income risk. Optimal portfolios are internationally diversified while positive correlation between domestic stock market returns and permanent labor income shocks can generate a complete portfolio specialization in foreign stocks. 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.

Item Type: Article
Official URL: http://www.elsevier.com/wps/find/journaldescriptio...
Additional Information: Copyright © 2003 Elsevier B.V. LSE has developed LSE Research Online so that users may access research output of the School. Copyright © and Moral Rights for the papers on this site are retained by the individual authors and/or other copyright owners. Users may download and/or print one copy of any article(s) in LSE Research Online to facilitate their private study or for non-commercial research. You may not engage in further distribution of the material or use it for any profit-making activities or any commercial gain. You may freely distribute the URL (http://eprints.lse.ac.uk) of the LSE Research Online website. A persistent link to the article is available at http://dx.doi.org/10.1016/S0165-1889(03)00035-6
Library of Congress subject classification: H Social Sciences > HB Economic Theory
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Departments > Economics
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: Published item via DOI
Date Deposited: 29 Jun 2006
URL: http://eprints.lse.ac.uk/195/

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