International risk sharing and portfolio choice with incomplete asset markets

This dissertation studies international portfolio decisions and transactions of U.S. investors. Chapter 1 addresses the question "Why do investors trade a lot in foreign assets and hold so little of them in their portfolios?" I show that both observations can arise naturally in the presence of nontraded consumption risk when each country specializes in production, preferences exhibit consumption home bias, and asset markets are incomplete. Using a general equilibrium two-country, two-sector model of the world economy I show that low diversification occurs because variations in relative prices (i) increase the riskiness of foreign returns; and (ii) facilitate risk-sharing across countries. Large and volatile capital flows are necessary to take advantage of international risk premia differentials that occur in response to productivity changes.;Chapter 2 develops a theoretical model that allows me to examine how greater integration in world financial markets affects the behavior of international capital flows and financial returns. The model predicts that international capital flows are large (in absolute value) and very volatile during the early stages of financial integration when international asset trading is concentrated in bonds. As integration progresses and households gain access to world equity markets, the size and volatility of international bond flows fall dramatically, but continue to exceed the size and volatility of international equity flows. This is the natural outcome of greater risk sharing facilitated by increased integration.;The results in chapters 1 and 2 are based on a new solution technique developed in Chapter 3. It presents a new numerical method for solving general equilibrium models with many assets. The method can be applied to models where there are heterogeneous agents, time-varying investment opportunity sets, and incomplete markets. It also can be used to study models where the equilibrium dynamics are non-stationary. I illustrate how the method is used by solving a one- and two-sector versions of a two-country general equilibrium model with production. I check the accuracy of the method by comparing the numerical solution to the one-sector model against its known analytic properties. The method is then applied to the two-sector model for which no analytic solution is available.