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International Portfolio Allocation under Model Uncertainty

Pierpaolo Benigno and Salvatore Nisticò
American Economic Journal: Macroeconomics
Vol. 4, No. 1 (January 2012), pp. 144-189
Stable URL: http://www.jstor.org/stable/41426392
Page Count: 46
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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.

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