Chapter 1 proposes a two-country general equilibrium model with external habits and home-biased preferences that addresses a number of international finance puzzles. Specifically, the model reconciles the high degree of international risk sharing implied by relatively smooth exchange rates with the modest cross-country consumption growth correlations seen in the data, resolving the Brandt, Cochrane and Santa-Clara (2006) puzzle. Furthermore, the model matches the empirically observed low correlation between exchange rate changes and international consumption growth rate differentials. For both effects, the fundamental mechanism is time variation in consumption growth volatility, which is endogenously generated through international trade. Asset prices depend on a weighted average of the two countries' time-varying risk aversion, with the weights determined by the wealth and degree of home bias of each country. Simulation results indicate that the model is successful in matching key empirical asset pricing, exchange rate and international trade moments.
Chapter 2 examines international portfolio choice in a two-country general equilibrium setting which features time-varying risk aversion generated by external habit formation. I show that, under complete markets, home bias in the consumption preferences leads to significant portfolio home bias due to differential hedging demands. Domestic (foreign) agents shift their portfolio towards domestic (foreign) assets, so as to better hedge against adverse changes in their conditional risk aversion. Furthermore, the model generates realistic asset pricing moments, thus reconciling international portfolio choice with asset pricing.