A Dynamic Equilibrium Model of Imperfectly Integrated Financial Markets
We build a continous-time general equilibrium model of a two-country, pure-exchange economy featuring taxes on the repatriation of dividends. We find approximate closed-form expressions for asset prices, returns joint dynamics and equity portfolios, thus giving a full description of equilibrium in-between the polar cases of perfect integration and full segmentation. We show that large home bias in portfolios can result from small frictions on international financial markets. The reason is that, partly due to portfolio rebalancing, the international correlation of returns is very high - making assets close substitutes and implying that slight frictions have a dramatic effect on portfolio composition.