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Explaining External Asset Allocation: A Multi-Country Model with Preference Heterogeneity

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One of the most defining features of economic development in the past twenty years has been the growth in cross-border financial asset holdings. This paper proposes a microfounded, multi-country model with endogenous external asset allocation and preference heterogeneity in consumption tastes. The model is solved by generalising the method for determining country asset portfolios proposed by Devereux and Sutherland (2008) to assets denominated in different currencies and multiple countries. The resulting model yields a rich set of theoretical results relating country portfolios to macroeconomic fundamentals and consumption preferences. It is the first to replicate observed patterns of asset allocation not only across asset classes, but also countries. Notably, the model replicates positive net holdings of equity and negative net holdings of debt securities for the US and the UK, matched by negative net holdings of equity and positive net holdings of debt securities for the Asian region. It also replicates the disproportionate share of the UK issued debt securities in debt security portfolios of other regions, endogenously yielding its role as a financial centre.

This talk is part of the Cambridge Finance Workshop Series series.

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