Home Bias and High Turnover: Dynamic Portfolio Choice with Incomplete Markets
36 Pages Posted: 15 Sep 2008
Date Written: June 30, 2008
Abstract
Why do investors trade a lot in foreign assets and hold so little of them in their portfolios? This paper shows that both observations can arise naturally in the presence of nondiversifiable nontraded consumption risk when each country specializes in production, preferences exhibit consumption home bias, and asset markets are incomplete. Using a general equilibrium two-country, two-sector (tradable and nontradable) model of the world economy with production I show that low diversification occurs because variations in relative prices (i) increase the riskiness of foreign assets and (ii) facilitate risk-sharing across countries. Large and volatile capital flows are necessary to take advantage of international risk premia differentials that occur in response to productivity changes in the nontradable sector. I characterize the optimal portfolio holdings, the evolution of the investment opportunity set, the risk premium, and the dynamics of capital flows using a new methodology for solving dynamic general equilibrium models with incomplete markets and portfolio choice.
Keywords: Home Bias, Dynamic Portfolio Choice, Incomplete Markets, Capital Flows, Mean-Variance Efficiency
JEL Classification: C68, D52, G11
Suggested Citation: Suggested Citation
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