Internationally Diversified Portfolios: Welfare Gains and Capital Flows

The models of portfolio balance developed by Markowitz and Tobin explain the real world phenomenon of diversified asset holdings elegantly and properly. The models have been criticized, extended, and empirically tested; by now their basic content has become economic orthodoxy. Strangely, however, the analysis has not yet been applied explicitly to the explanation of long-term asset holdings that include claims denominated in foreign currency .The present paper fills this gap and yields some interesting results.First, the international diversification of portfolios is the source of an entirely new kind of world welfare gains from international economic relations, different from both the traditional "gains from trade" and in­ creased productivity flowing from the migration of the factors of pro­ duction. This specific theoretical proposition is illustrated with some calculations based on empirical data drawing on ex post realized rates of return from investment in 11 major stock markets of the world.Second, the theoretical model shows that international capital movements are a function not only of interest rate differentials but also of rates of growth in total asset holdings in two countries. As a result, capital may flow between countries when interest rate differentials are zero or negative and may not flow when a positive interest differential exists.Third, the analysis has some important policy implications in a growing world where monetary and fiscal policies are mixed to achieve internal and external balance.