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  3. American Economic Journal: Macroeconomics
  4. January 2012
  5. International Portfolio Allocation under Model Uncertainty

International Portfolio Allocation under Model Uncertainty

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Abstract

This paper revisits an old argument, hedging real exchange rate risk, as an explanation of the international home bias in equity. In a dynamic model, the relevant risk to be hedged is the long-run risk as opposed to the short-run risk. Domestic equity is indeed a good hedge with respect to long-run real-exchange-rate risk. Two new frameworks are able to explain a large share of the observed US home bias: a model with Hansen-Sargent preferences in which agents fear model misspecification and a model with Epstein-Zin preferences. These two models are also immune to the risk-free rate puzzle. (JEL C58, F31, G11, G15)

Citation

Benigno, Pierpaolo, and Salvatore Nisticò. 2012. "International Portfolio Allocation under Model Uncertainty." American Economic Journal: Macroeconomics, 4 (1): 144-89. DOI: 10.1257/mac.4.1.144

Additional Materials

JEL Classification

  • C58 Financial Econometrics
  • F31 Foreign Exchange
  • G11 Portfolio Choice; Investment Decisions
  • G15 International Financial Markets
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