Portfolio Choice in a two country model

Hello Prof. Pfeiffer,

first and foremost I want to thank you for all the insights and answers you provide in this forum. I am working on a two country model with endogenous portfolio choice and as I scanned through the forum it seems like the only way (at least in Dynare) to solve for the equilibrium portfolios is to use the method by Devereux and Sutherland (2008).

Please correct me if I am wrong but I am wondering if one could also approximate the whole model up to 2nd/3rd order and simulate the ergodic mean in the absence of shocks (as you do in your replication of the Basu and Bundick (2017) paper), provide the calculated stochastic steady state as a new steady state and let dynare approximate the model around that new steady state. Because the latter is not the deterministic, but the stochastic steady state one could use the command that tells dynare to not explicitly check if the provided steady state is an actual deterministic steady state. Would that possibly be an alternative or am I missing something important?

Thanks in advance,

I don’t think that this would really work. Even if you get the stochastic steady state, you would still need to solve for the portfolio allocation.

Dear Prof. Pfeiffer,

thanks for the fast reply. Currently I close the model by putting a very small risk premium in the two UIP conditions, which depends on the foreign bond holdings (the ones that enter the budget constraint). This causes them to be zero in the deterministic steady state as both countrys face the same steady state interest rate. When I computed the stochastic steady state following your example, the foreign bond holdings in the stochastic steady state are no longer zero but in fact positive (as the literature would suggest, as consumption and the foreign exchange rate are negatively correlated). Due to symetry, the net foreign asset position and current account are of course still 0 in the stochastic steady state, but it seems like that the portfolio decision seems to be determined in the stochastic steady state. My problem is, that I get this result only because I made the risk premium in the UIP condition dependend on the foreign asset position and thus the UIP conditions in combination with the covariance of the stochastic discount factor and the exchange rate pin down the foreign bond holdings in the stochastic steady state. My intuition was that I could use the stochastic steady state (that includes positive foreign bond holdings) and tell dynare to approximate the functions around that new steady state. But probably that intuition was flawed and not well thought through. Thanks for the reply, I will keep on thinking about it.