International Portfolio Investments with Trade Networks

Abstract

What determines the composition of international portfolio investments remains an open question in international finance. In this paper, I propose a theory of international portfolio choice where trade networks play a key role. I solve in closed form for the optimal equity and bond portfolio investments in a multi-country model with arbitrary global input - output linkages and taste differences. I show that a measure of international demand exposure, called the “International Domar Weights” (IDWs), is key in determining international equity portfolios. The IDWs extend the closed-economy “Domar weights” to the international setting and capture countries' interdependence through both direct and indirect trade linkages. Using data from the World Input - Output Database (WIOD) and Coordinated Portfolio Investment Survey (CPIS), I apply the framework to a network of 43 major developed and emerging economies and obtain four main results. First, the theoretical network portfolio is a significant predictor and explains almost half of the variation in international bilateral portfolio investments. The significance of the network portfolio is robust to controlling for gravity factors (market capitalization, distance, EU membership, etc.). Second, including the network-based portfolio in a gravity model for assets resolves the puzzle of why distance matters for asset trade at all. Third, indirect trade linkages matter for portfolio determination, highlighting the need to explicitly account for trade in intermediate inputs. Finally, the model predicts both the levels and the changes in equity home bias that have occurred since 2000.