The International Diversification Puzzle when Goods Prices Are Sticky: It's Really About Exchange-Rate Hedging, not Equity Portfolios
IMF Working Papers, January 1, 2009
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- The International Diversification Puzzle when Goods Prices Are Sticky: It's Really About Exchange-Rate Hedging, not Equity Portfolios
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Bibliographic details
- Authors: Akito Matsumoto, Charles Engel
- Published: January 1, 2009
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451871593.001
Model and setup
- Two-country monetary DSGE model in which households choose:
- a portfolio of home and foreign equities, and
- a forward position in foreign exchange.
- Some nominal goods prices are sticky.
- In the linearized model, trade in equities and forward positions achieves the same allocations as trade in a complete set of nominal state-contingent claims.
Key findings
- When there is a high degree of price stickiness:
- Not much equity diversification is required to replicate the complete-markets equilibrium when agents can hedge foreign exchange risk sufficiently.
- Temporarily sticky nominal goods prices can have large effects on equity portfolios even when dividend processes are very persistent.
Themes and implications
- Exchange-rate hedging:
- Central to attaining allocations close to complete-markets outcomes in the presence of sticky goods prices.
- More important than cross-border equity diversification for replicating risk-sharing outcomes under price stickiness.
- Equity portfolio composition:
- Sensitive to nominal price stickiness; temporary rigidities can materially alter international portfolio allocations despite persistent dividend processes.
- Asset structure equivalence:
- In the linearized model, trading equities plus forward FX positions is equivalent to trading a complete set of nominal state-contingent claims.