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A dynamic equilibrium of imperfectly integrated financial markets

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Nicolas Coeurdacier

Abstract

This paper analyzes the determination of equity portfolios and country stock returns in the context of imperfectly integrated stock markets. We consider a continuous-time model of a two-country endowment economy in which the level of financial integration is captured by a proportional tax on foreign dividends. Despite the heterogeneity among investors induced by this tax, we obtain approximate closed-form expressions for asset prices and we characterize equity holdings and the joint process followed by country stock returns in equilibrium. Our model is consistent with a broad range of empirical findings on international financial integration. When the (endogenous) cross-country return correlation is high, small frictions in equity markets can generate a substantial home bias in portfolios. In the baseline version of our model, the cross- country return correlation is driven by fundamental correlation and portfolio rebalancing. In a two-good extension of the model, the adjustment of relative good prices can generate high stock return correlation even for a low level of fundamental correlation, thus magnifying the impact of the financial friction on portfolios.
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hal-03602487 , version 1 (09-03-2022)

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Nicolas Coeurdacier, Stéphane Guibaud. A dynamic equilibrium of imperfectly integrated financial markets. 2008. ⟨hal-03602487⟩

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