International Portfolios with Demand and Supply Shocks

In the past twenty years, both gross and net capital flows have increased to unprecedented levels (see Lane and Milesi-Ferretti b, 2006). In industrialized countries, this has been the case for both stocks and bonds. One consequence of this period of financial integration is that gross financial positions now exceed 100% of GDP in several industrialized countries. This also means that differences in returns on foreign assets held by domestic agents and on domestic assets held by foreign agents can generate sizable wealth transfers between countries. Lane and Milesi-Ferretti (2006 a and b) and Tille (2003).have recently shown the extent of these valuation effects. The financial integration process at work in the past twenty years has not however eliminated the financial home bias in stocks. The theoretical literature has analyzed these two issues the financial home bias and the valuation effects separatly. In this paper, we study them jointly in a two country general equilibrium model with portfolio choice and show that they can be related. We analyze them in the context of the stylized fact of the ∗ESSEC Business School, Av. Bernard Hirch, 95021 Cergy Pontoise Cedex, France. Email: [email protected] †ULB ‡Université Paris 1 Panthéon Sorbonne, Paris School of Economics, and CEPR