In simple one-good international macro models, the presence of non-diversiable labor income risk means that country portfolios should be heavily biased toward foreign assets. The fact that the opposite pattern of diversication is observed empirically constitutes the international diversication puzzle. This paper embeds a portfolio choice decision in a two-country, two-good version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, equilibrium country portfolios can be characterized in closed form.

Portfolios are biased towards domestic assets, as in the data. Home bias arises because openness to trade, through endogenous international relative price 
uctuations, reduces co-movement between relative income from labor and relative income from capital, making domestic assets a good hedge against non-diversiable labor income risk. Evidence from developed economies in recent years is qualitatively and quantitatively consistent with the mechanisms highlighted by the theory.