International Portfolio Choice and Liquidity Constraints: Can Small Information Costs Explain the Home Equity Bias Puzzle?

This paper solves for optimal international portfolio choice in the presence of liquidity constraints and undiversifiable labor income risk. Optimal portfolios are internationally diversified while positive correlation between domestic stock market returns and permanent labor income shocks can worsen the home equity bias puzzle. Nevertheless, either small information costs associated with investing abroad or a slightly positive domestic to foreign equity premium differential are sufficient to either deter households from participating in a foreign market or generate a substantial bias for home equities. The benefits of international diversification are limited because consumption fluctuations can be smoothed with a small amount of buffer stock saving while exchange rate risk makes foreign investments less appealing to risk averse investors.