International Portfolios: A Comparison of Solution Methods

Substantial progress has been made in recent years in integrating optimal portfolios into (open macro) general equilibrium models using standard local approximation (perturbation) methods. We compare these perturbation-based portfolio solution methods with a global portfolio solution method to evaluate their relative performance. We find that the the local method performs very well when the model features and parameters are aimed at capturing macro stylized facts only, and in symmetric country setups. It performs much less well when the model includes features from the finance literature that have been shown to be important in jointly explaining macro- and asset pricing stylized facts, such as Epstein-Zin preferences, or in a model with positive expected excess returns (equity premia). Also, in asymmetric country setups a 'wrong' approximation of the net foreign asset (NFA) position can strongly compromise the performance of the local portfolio solution method whenever the true policy functions are nonlinear in the NFA.