Theory and Policy, and at the North American Winter Meeting of the Econometric Society for useful comments. We are

Abstract: The objective of this paper is to understand three stylized facts observed in industrialized countries: 1) portfolios are biased on local equity; 2) international portfolios are long in foreign currency and short in domestic currency; 3) valuation effects are such that an exchange rate depreciation is associated to a positive transfer of wealth. We build a two-country, two-good model with stocks and bonds where uncertainty is not only due to productivity shocks but also due to shocks on the distribution of income between labor and capital and to demand shocks. We show that, in this case, optimal portfolios are broadly consistent with the above stylized facts. We perform this analysis both in situations of complete and incomplete markets