Role of portfolio constraints in the international propagation of shocks

Pavlova, A and Rigobon, R (2008) Role of portfolio constraints in the international propagation of shocks. Working Paper. London Business School Review of Economic Studies.

Abstract

We study the comovement among stock prices and among exchange rates in a threegood threecountry CenterPeriphery dynamic equilibrium model in which the Center's agents face portfolio constraints.We characterize equilibrium in closed form for a broad class of portfolio constraints, solving for stock prices, terms of trade, and portfolio holdings. We show that portfolio constraints generate wealth transfers between the Periphery countries and the Center, which increase the comovement of the stock prices across the Periphery. We associate this excess comovement caused by portfolio constraints with the phenomenon known as contagion. The model generates predictions consistent with other important empirical results such as amplification and flighttoquality effects.