TY  - JOUR
AU  - Heathcote,Jonathan
AU  - Perri,Fabrizio
TI  - The International Diversification Puzzle Is Not As Bad As You Think
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 13483
PY  - 2007
Y2  - October 2007
UR  - http://www.nber.org/papers/w13483
L1  - http://www.nber.org/papers/w13483.pdf
N1  - Author contact info:
Jonathan Heathcote
Federal Reserve Bank of Minneapolis
Research Department
90 Hennepin Ave.
Minneapolis, MN 55401
Tel: (612) 204-6385
E-Mail: heathcote@minneapolisfed.org

Fabrizio Perri
University of Minnesota
Department of Economics
4-177 Hanson Hall
Minneapolis, MN 55455
Tel: 612/625-7504
Fax: 612/624-0209
E-Mail: fperri@umn.edu
AB  - In simple one-good international macro models, the presence of non-diversifiable labor income risk means that country portfoliosshould be heavily biased toward foreign assets. The fact that theopposite pattern of diversification is observed empirically constitutes the international diversification puzzle. We embed aportfolio choice decision in a frictionless two-country, two-good version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, we derive a closed-form expression for equilibrium country portfolios. These are biased towards domestic assets, as in the data. Home bias arises because endogenous international relative price fluctuations make domestic stocks a good hedge against non-diversifiable labor income risk. We then use our our theory to link openness to trade to the level of diversification, and find that it offers a quantitatively compelling account for the patterns of international diversification observed across developed economies in recent years.
ER  -