Two Trees, Asset Pricing with Heterogenous Investors, Home Bias in Portfolios, International Stock Return Correlations, Financial Integration
JEL:
G15, F37, G11, G12, F36
Abstract:
This paper analyzes the determination of equity portfolios and country stock returns in
the context of imperfectly integrated stock markets. We consider a continuous-time model of
a two-country endowment economy in which the level of financial integration is captured by a
proportional tax on foreign dividends. Despite the heterogeneity among investors induced by this
tax, we obtain approximate closed-form expressions for asset prices and we characterize equity
holdings and the joint process followed by country stock returns in equilibrium. Our model is
consistent with a broad range of empirical findings on international financial integration. When
the (endogenous) cross-country return correlation is high, small frictions in equity markets can
generate a substantial home bias in portfolios. In the baseline version of our model, the cross-
country return correlation is driven by fundamental correlation and portfolio rebalancing. In a
two-good extension of the model, the adjustment of relative good prices can generate high stock
return correlation even for a low level of fundamental correlation, thus magnifying the impact
of the financial friction on portfolios.
