The international diversification puzzle is not as bad as you think 1

In one-good international macro models with non-diversifiable labor income risk country portfolios are heavily biased toward foreign assets. The fact that the opposite pattern of diversification is observed empirically constitutes the international diversification puzzle. This paper embeds a portfolio choice decision in a two-country, two-good version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, equilibrium country portfolios can be characterized in closed form. Portfolios are biased towards domestic assets, as in the data. Home bias arises because endogenous international relative price fluctuations make domestic assets a good hedge against labor income risk. Evidence from developed economies in recent years is qualitatively and quantitatively consistent with the mechanisms highlighted by the theory. keywords: Country portfolios, International business cycles, Home bias jel classification codes : F36, F41 The views expressed herein are those of the authors and no necessarily those of the Federal Reserve Bank of Minneapolis, or the Federal Reserve System. We thank Sebnem Kalemli-Ozcan, Nobu Kiyotaki and Eric Van Wincoop for thoughtful discussions, the editor, two referees, and seminar participants at numerous institutions for very helpful comments. The datasets and computer code used in the paper are available on our websites.