Trade Costs, Heterogeneous Firms and International Portfolio Choice Daniel Andrei Gerzensee, June 2 2008

3. Benchmark Model & Solution method 1. Motivation 2. Literature 3. Benchmark Model & Solution method 4. Heterogeneous Firms 5. Conclusion & Discussion 1/15

World Market Capitalization   2/15

World Market Capitalization   U.S. Market Cap (40% in 2005) 2/15

World Market Capitalization   U.S. Market Cap (40% in 2005) 2/15

World Market Capitalization   U.S. Market Cap (40% in 2005) All investors should hold the market portfolio => U.S. investors should hold 40% of domestic equities 2/15

World Market Capitalization   True proportion of domestic equities in U.S. portfolios was 82% in 2005 U.S. Market Cap (40% in 2005) All investors should hold the market portfolio => U.S. investors should hold 40% of domestic equities 2/15

? World Market Capitalization 2/15   HOME EQUITY BIAS True proportion of domestic equities in U.S. portfolios was 82% in 2005 ? U.S. Market Cap (40% in 2005) All investors should hold the market portfolio => U.S. investors should hold 40% of domestic equities 2/15

Potential Explanations Hedging domestic risks Costs and barriers for foreign investments Information asymmetries Corporate governance and transparency Behavioral-based explanations 4/15

Potential Explanations Hedging domestic risks Costs and barriers for foreign investments Information asymmetries Corporate governance and transparency Behavioral-based explanations Recently, new methods have been developped to solve for optimal portfolios in DSGE models: Devereux and Sutherland (2006), Tille and Van Wincoop (2007), Evans and Hnatkovska (2005) 4/15

Potential Explanations Hedging domestic risks Costs and barriers for foreign investments Information asymmetries Corporate governance and transparency Behavioral-based explanations Recently, new methods have been developped to solve for optimal portfolios in DSGE models: Devereux and Sutherland (2006), Tille and Van Wincoop (2007), Evans and Hnatkovska (2005) THIS PAPER: (1) Solve for optimal portfolios in a two-country DSGE model. (2) Show how in a setup with heterogeneous firms and fixed export costs we can obtain home equity preference. 4/15

Some related literature: Lucas (1982) Uppal (1993) Cole and Obstfeld (1991) Baxter and Jermann (1997) Obstfeld and Rogoff(2006) Kollmann (2006) Coeurdacier et. al. (2007) Coeurdacier (2006) Van Wincoop and Warnock (2007) Hnatkovska (2005) 5/15

Some related literature: Lucas (1982) Uppal (1993) Cole and Obstfeld (1991) Baxter and Jermann (1997) Obstfeld and Rogoff(2006) Kollmann (2006) Coeurdacier et. al. (2007) Coeurdacier (2006) Van Wincoop and Warnock (2007) Hnatkovska (2005) Extensions: Heterogeneous firms Non-tradable sector Fixed costs to go to export market BENCHMARK MODEL Show the difficulties to explain the home equity bias Show why we can obtain home equity bias 5/15

If goods are shipped to the another country, then a fraction τ is lost in transit (melting-iceberg trade costs) Export Export

Take difference: 7/15

Take difference: Treat this temporarily as an exogenous i.i.d. variable 7/15

Treat this temporarily as an exogenous i.i.d. variable 7/15

Treat this temporarily as an exogenous i.i.d. variable 7/15

Treat this temporarily as an exogenous i.i.d. variable 7/15

=> Closed form solution: 7/15

=> Closed form solution: 7/15

DOMESTIC EQUITY HELD BY DOMESTIC RESIDENTS: 7/15

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Heterogeneous Firms : Setup Pareto Distribution with parameters zmin and k Productivity 10/15

Heterogeneous Firms : Setup Pareto Distribution with parameters zmin and k Non-exporting firms Exporting firms Productivity This firm will earn exactly zero export profits 10/15

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Fixed export costs can vary => Incomplete Markets 13/15

Fixed export costs can vary Number of exporting firms can vary => Incomplete Markets 14/15

CONCLUSIONS Re-confirm that proportional trade costs cannot lead to home bias. Fixed export costs can help. The mechanism: decrease correlation between labor income and capital income. Incomplete markets can help: more robust results and better outcomes in terms of VWW statistic and consumption – RER anomaly. Show how a productivity shock can transform into a redistributive shock. Introduce demand shocks into a more intuitive way. 15/15

Benchmark Model Heterogeneous Firms Model