Usc Fbe Dept. Macroeconomics & International Finance Workshop

In the data country portfolios are heavily biased toward domestic assets. Standard onegood international macro models predict that, due to the presence of non-diversifiable labor income risk, country portfolios should be heavily biased toward foreign assets; this discrepancy constitutes the international diversification puzzle (Baxter and Jermann, 1997). We show that a simple extension of one-good models help to reconcile theory and data. In particular we analytically solve for the equilibrium country portfolios in a two-country, two-goods model with non-diversifiable labor income and investment. In this set-up, consistently with the data, country portfolios contain a relatively small, but positive, share of foreign assets. The reason why international diversification is low is that terms of trade movements provide considerable insurance against country specific shocks and labor income risk (Cole and Obstfeld 1991, Acemoglu and Ventura, 2002, Pavlova and Rigobon, 2003). The reason why international diversification is positive is that foreign assets are crucial to share the financing of investment across countries. Finally in the model a country’s portfolio share of foreign assets should depend on its trade/GDP ratio and on its capital income/GDP ratio. We show how this relation is qualitatively and quantitatively consistent with country portfolios in the cross section of OECD countries in the 1990s. keywords: Home bias, international diversification jel classication codes : F36, F41 We thank Sebnem Kalemli-Ozcan Nobu Kiyotaki and Eric Van Wincoop for thoughtful discussions and seminar participants at the Board of Governors, Bank of Canada, Boston College, Chicago, Cornell, Federal Reserve Banks of Chicago, Cleveland and Richmond, Georgetown, Harvard, IMF, MIT, NYU, Penn, Princeton, Stanford, SUNY Albany, Texas Austin, Wisconsin, the 2004 AEA Meetings, CEPR ESSIM, SED, Minnesota Workshop in Macroeconomics Theory and NBER EFG summer meeetings. for very helpful comments USC FBE DEPT. MACROECONOMICS presented by Fabrizio Perri THURSDAY, May 3, 2007 3:30 pm – 5:00 pm, Room: HOH-601K & INTERNATIONAL FINANCE WORKSHOP