International portfolios, capital accumulationand foreign assets dynamics

Cross-country capital flows have increased greatly, since the liberalization of internationalcapital markets two decades ago. Equity home bias, while less severe than earlier, remains sizeableand is observed in all industrialized countries. There are broadly two classes of explanations for thepersisting home bias. The first one centers on transaction costs and information barrieres in cross -border financial transactions and suggest that international risk sharing is insufficient. The secondfocuses on the possibility that the terms of trade changes in response to supply shocks may provideinternational insurance against these shocks, so that even a portfolio with home bias delivers efficientinternational risk sharing. Both explanations are helpful but not without problems. Several authorshave argued that frictions would have to be large to fully explain the equity home bias. In order tointerpret terms of trade changes as providing insurance, the terms of trade would have to improvestrongly after a negative supply shock. However, empirically the terms of trade are only weaklycorrelated with output.[...]