International Portfolios with Supply, Demand, and Redistributive Shocks

This chapter explains three key stylized facts observed in industrialized countries: (a) portfolio holdings are biased toward local equity; (b) international portfolios are long in foreign currency assets and short in domestic currency; (c) the depreciation of a country's exchange rate is associated with a net external capital gain i.e., with a positive wealth transfer from the rest of the world. We present a two-country, two-good model with trade in stocks and bonds, and three types of disturbances: shocks to endowments, to the relative demand for home versus foreign goods, and to the distribution of income between labor and capital. With these shocks, optimal international portfolios are shown to be consistent with the stylized facts.