A Dynamic Equilibrium Model of International Portfolio Holdings

This paper develops a continuous‐time equilibrium model of a two‐country exchange economy with heterogeneous agents and nontraded goods. Nontraded goods play the role of state variables that shift the marginal utility of traded goods. This affects prices and generates dynamic hedging demands that explain the well documented home bias puzzle in international equity portfolios. When calibrated to both consumption and production data, the model is able to generate significative home bias in equity portfolios. A new methodology, based on Malliavin calculus, is presented to solve for the portfolio policies along the equilibrium path. This methodology allows one to reduce the determination of equilibrium portfolio holdings to the solution of a linear algebraic system, rather than a partial differential equation.