International Portfolio Allocation under Model Uncertainty

Pierpaolo Benigno, Salvatore Nisticò

NBER Working Paper No. 14734
Issued in February 2009, Revised in December 2011
NBER Program(s):Asset Pricing, International Finance and Macroeconomics, Monetary Economics

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.

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Document Object Identifier (DOI): 10.3386/w14734

Published: Pierpaolo Benigno & Salvatore Nistico, 2012. "International Portfolio Allocation under Model Uncertainty," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(1), pages 144-89, January. citation courtesy of

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