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Abstract

During the financial crisis that first hit the U.S. economy and soon became a world crisis, investors reduced their holdings of foreign equities, and, at the same time, they increased their holdings of short-term government bonds. The paper analyzes, within the context of a DSGE model, the hedging properties of foreign bond and foreign equity holdings during a crisis, when the degree of uncertainty is high. I show that uncertainty generates portfolio dynamics and that they differ depending on the source of uncertainty. Investors increase their holdings of foreign government bonds and, at the same time, reduce their holdings of foreign corporate equities, when uncertainty originates from aggregate demand. When instead uncertainty originates from aggregate supply, it is optimal for investors to reduce their holdings of foreign bonds and increase their holdings of foreign equity. These findings are supported by the recently developed theories that consider the collapse of aggregate demand the main cause of the “Great Slump” that started in 2007.

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