International equity and bond positions in a DSGE model with variety risk in consumption

This paper analyzes equity and bond positions in a two-country Dynamic Stochastic General Equilibrium model where the number of varieties, i.e., the extensive margins of products available to consumers, is endogenously determined. Fluctuations in the welfare-based real exchange rate, including those in the number of varieties, matter to international consumption risk sharing. We investigate the implication of such “variety risk” for the optimal portfolio choice and show that the variety risk generates home-biased equity positions, strengthening those obtained with the standard model in the literature. We also find preliminary empirical support for the mechanism. •We examine the international equity and bond positions in a DSGE model with firm entry.•The “home biased equity positions” are further strengthened with firm entry and induced variety risk.•The results are robust with or without firm heterogeneity in marginal cost of production.•We also provide preliminary empirical evidence on the mechanism argued in the paper.