International Portfolio Allocation Under Model Uncertainty

39 Pages Posted: 21 Feb 2009 Last revised: 6 Oct 2022

See all articles by Pierpaolo Benigno

Pierpaolo Benigno

University of Bern - Department of Economics

Salvatore Nisticò

Sapienza University - Department of Social Science and Economics

Date Written: February 2009

Abstract

This paper proposes an explanation of the international home bias in equity based on ambiguity aversion. Doubts imply an additional hedging motif driven by the interaction between real exchange rate risk and ambiguity aversion. What matters is the long-run as opposed to the short-run risk. Domestic equity is a good hedge with respect to long-run real exchange rate risk even when bonds are traded. The higher is the degree of ambiguity aversion, the stronger is the home bias. We identify the degree of ambiguity aversion with detection error probabilities and show that our framework is able to explain a large share of the observed US home bias, as well as other stylized facts on US cross-border asset holdings. Without doubts, a standard open-economy macroeconomic model would be unsuccessful along all these dimensions.

Suggested Citation

Benigno, Pierpaolo and Nisticò, Salvatore, International Portfolio Allocation Under Model Uncertainty (February 2009). NBER Working Paper No. w14734, Available at SSRN: https://ssrn.com/abstract=1347217

Pierpaolo Benigno (Contact Author)

University of Bern - Department of Economics ( email )

Schanzeneckstrasse 1
Bern, CH-3001
Switzerland

Salvatore Nisticò

Sapienza University - Department of Social Science and Economics ( email )

Piazzale Aldo Moro 5
Rome, 00185
Italy

HOME PAGE: http://sites.google.com/view/salvatore-nistico

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