On the Effects of Barriers to International Investment

A simple model is presented in which it is costly for domestic investors to hold foreign assets. The implications of the model for the composition of optimal portfolios at home and abroad are derived. It is shown that all foreign assets with a beta larger than some beta ,/* plot on either one of two security market lines. Some foreign assets with a beta smaller than /* are not held by domestic investors even if their expected return is increased slightly. WHILE IT IS OBVIOUSLY not true that asset markets are completely segmented between countries, there is evidence of barriers to international investment. Although reality seems to lie in that grey area between complete segmentation and no segmentation at all, most international asset pricing models are concerned with the extreme case of no barriers to international investment. No effort seems to have been made to study the effect on portfolio choice of such barriers, which make it costly to hold foreign securities, as opposed to domestic securities, but which do not, in general, render international diversification so onerous that investors avoid foreign securities completely.' Casual empiricism suggests that models without barriers to international investment should be suspect; those models cannot explain why it appears that in every country investors, on average, hold more domestic securities than would be required if they held the world market portfolio.2 This paper constructs a model of international asset pricing in which there is a cost associated with holding-either long or short-risky foreign securities. For the sake of simplicity, in most of the paper we assume that while domestic investors face barriers to international investment, foreign investors face no such barriers. It turns out that nothing significant is lost with such an assumption. The main conclusions of this paper for the case in which foreign investors face no barriers to international investment are: 1. In the presence of barriers to international investment, some risky foreign