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We develop a tractable asset pricing model of international equity markets to investigate the impact of frictions in cross-border financial investments on equity return dynamics and cross-border equity holdings across countries. We characterize the equilibrium of the model analytically at the limit as one country becomes large relative to all other countries. Our results clarify the distinct impact of cross-border holding costs, cash-flow fundamentals comovement, and preferences on cross-border portfolio holdings, return comovement, and risk premia. The model offers a unified explanation for key empirical regularities in the cross-section of equity markets regarding cross-country return correlations, CAPM pricing errors, and equity portfolio home bias, which we document using aggregate return and portfolio holdings data from the U.S. and a cross-section of 40 other countries. Overall, our results suggest that asset pricing tests for international equity markets should take into account differences across countries in the degree of cross-border frictions.


Cross-border investment frictions, holding costs, cross-section of return correlations, cross-border portfolio holdings, international asset pricing, home bias


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