Asset Prices, Global Portfolios, and the International Financial System

Abstract

I characterize the global solution to the international portfolio problem in full generality, a long-standing open issue in international finance. In this two-country two-good environment, investors have recursive preferences and a bias in consumption towards their local good. The framework highlights the role of the allocation of wealth across international investors for portfolios, asset prices, and risk sharing, an aspect that had received little emphasis in such a setting. The influence of the allocation of wealth grows especially as markets become imperfectly integrated, and as investor heterogeneity rises – be it through a larger home bias in consumption, the introduction of labor income, or asymmetries in preferences – to the point where it can match or surpass the impact of fundamentals. The framework lends itself to several applications and extensions. In particular, I show that it can replicate a number of facts about the structure and dynamics of the international financial system, and of asset returns in that context.