Country Portfolios with Heterogeneous Pledgeability

Abstract

In this paper, I study the international transmission of shocks when assets traded across borders are differently suitable as collateral for borrowing (i.e., pledgeability). Under finan- cial integration, differences in pledgeability have implications for the demand for assets. For instance, if a shock makes it more difficult to pledge the assets of the country receiving the shock, agents expect these assets to yield a relatively higher premium than foreign assets in the near future. I develop an approach to determine the optimal portfolio allocations, as existing methods cannot be directly applied to capture differences in asset pledgeability. In this case of heterogeneously pledgeable assets, financial shocks are transmitted from one country to another because the same asset is held by residents of different countries. Valu- ation effects arise as a consequence of the reaction of asset returns in different countries. In contrast, a standard model cannot generate any of these implications when assets have the same degree of pledgeability. Indeed, when assets have the same degree of pledgeability, financial shocks are country-specific and hinder the access to credit only for the residents of the country hit by the shock.