Abstract
We develop a model of international portfolio choice in complete and incomplete markets with stochastic covariance between financial asset returns and exchange rates. The optimal investment strategies are derived in closed form. We estimate the model parameters and illustrate the optimal investment based on two stock indices, S\&P500 and DAX using the USD-EUR exchange rate. We analyse the welfare losses due to various suboptimal investment strategies, in particular we find that investors who invest myopically in complete markets or ignore derivative assets can incur substantial welfare losses. Furthermore, we find strong evidence that the welfare benefits from international diversification are significant. It is also shown that the model satisfies several stylized facts well known in the literature for the equity market.
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