Asset pricing in open economies with incomplete markets: implications for foreign currency returns

This paper extends the incomplete markets model in Constantinides and Duffie (1991. Asset Pricing with Heterogenous Consumers: Good News and Bad News. Manuscript, University of Chicago) to a two country, two goods framework adding another dimension to heterogeneity, viz. cross-country heterogeneity. The paper combines the heterogenous agent economy specified in Constantinides and Duffie with Cobb Douglas preferences as in Cole and Obstfeld (1991. Commodity trade and international risk sharing: how much do financial markets matter? Journal of Monetary Economics). The combination of iso-elastic preferences with an income process that incorporates permanent shocks that are heteroscedastic, results in an equilibrium where agents do not trade both within and across countries. The results on asset prices are similar to the one-country one-good model as in Constantinides and Duffie (1991). Despite heterogeneity, asset prices depend on aggregate endowments. Prices differ from those in the representative agent case on account of differences in the effective risk aversion and time preference rates. Effective risk aversion could be higher and the effective time preference lower compared to the complete markets case. The results on portfolio choice are similar to Cole and Obstfeld (1991) in that agents do not trade assets across countries.