International Portfolios, Capital Accumulation and Foreign Asset Dynamics International Portfolios, Capital Accumulation and Foreign Assets Dynamics

Despite the liberalization of capital ‡ows among OECD countries, equity home bias remains sizable. We depart from the two familiar explanations of equity home bias: transaction costs that impede international diversi…cation, and terms of trade responses to supply shocks that provide risk sharing, so that there is little incentive to hold diversi…ed portfolios. We show that the following ingredients are key for generating realistic equity home bias: shocks to total factor productivity and to the e¢ ciency of physical investment, as well as the possibility for agents to trade in stocks and bonds. In our model, domestic stocks are used to hedge ‡uctuations in local wage income triggered by shocks to investment spending. Terms of trade risk is hedged using bonds denominated in local goods and in foreign goods. In contrast to related models, the low level of international diversi…cation does not depend on the response of terms-of-trade to technology shocks. The model captures the fact that net exports are countercyclical. It also reproduces the cyclical dynamics of foreign asset positions and of international capital ‡ows. JEL classi…cation: F2, F3, G1. Keywords: international equity and bond portfolios; capital ‡ows; current account; capital accumulation; news shocks; valuation e¤ects. — — — — — — — — — — — — — — — — — — — — — – Work in progress.We thank Kosuke Aoki, Lieven Baele, Luca Dedola, Pierre-Olivier Gourinchas, Stéphane Guibaud, Harald Hau, Jonathan Heathcote, Mathias Ho¤mann, Akito Matsumoto, Gert Peersman, and Alan Sutherland for useful discussions. Thanks for useful comments are also due to workshop participants at the Royal Economic Society 2008 conference, IMF-JIE conference ”International Macro-Finance”, and at the Universities of Zurich and Ghent. R. Kollmann thanks ECARES and the National Bank of Belgium for …nancial support. N. Coeurdacier: Department of Economics; London Business School; Regent’s Park; London NW1 4SA; United Kingdom; [email protected]. R. Kollmann: ECARES; Université Libre de Bruxelles; 50 Av. Franklin Roosevelt; CP 114; B-1050 Brussels; Belgium; [email protected]. P. Martin: Université Paris I, 106-112 Blvd de l’Hôpital; 75013 Paris; France; [email protected].