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New Patterns in International Portfolio Allocation and Income Smoothing

Faruk, Balli (2006): New Patterns in International Portfolio Allocation and Income Smoothing.

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In the wake of monetary unification euro area bond and equitymarkets have become increasingly integrated. As an evidence of integration in those markets, the volume of international financial asset trading increased considerably. Nevertheless, the substantial decline in home bias among the members is accompanied with a bias of holding more assets from inside of euro area instead of outside which we refer to as ``euro bias."

First, this paper explains the euro portfolio bias with the decline primary market transaction costs(gross spread) and lower sovereign risk among euro members. Second and more importantly, we examine the consequences of this euro in bond and equity markets in aggregate data levels. We find that higher correlations among corporate bond prices and compression in government bond yield differentials lead negative effect on smoothing via factor income when the euro domestic investors have euro bond bias. However, in the equity markets, specialization in production among euro members made aggregate euro sector indices not affected from global and regional shocks. Hence, sector indices become the leading force of euro equity markets and create less correlated national stock markets among the markets. We concluded that the more domestic investors have a bias of holding their equity portfolios inside of euro region, i.e. the higher euro portfolio bias, the higher possibility for sharing their income risk exists.

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