We compare the performance of the perturbation-based (local) portfolio solution method of Devereux and Sutherland (2010a, 2011) with a global solution method. We find that the local method performs very well when the model is designed to capture stylized macroeconomic facts and countries/agents are symmetric, i.e. when the latter have similar size, face similar risks and trade assets with similar risk properties. It performs less satisfactory when the agents engaged in financial trade are asymmetric. The global solution method performs substantially better when the model is parameterized to match the observed equity premium, a key stylized finance fact. (authors' abstract) / Series: Department of Economics Working Paper Series

Using a stylized two period model we obtain portfolio solutions from two solution approaches that belong to the class of local approximation methods - the approach of Judd and Guu (2001, hereafter 'JG') and the approach of Devereux and Sutherland (2010, 2011,hereafter 'DS') - and compare them with the true portfolio solution. We parameterize the model to match mean, standard deviation, skewness and kurtosis of return data on aggregate MSCI stock market indices. The optimal equity holdings in the true solution depend on the size of uncertainty, and the precise form of this relationship is determined by the distributional properties of equity returns. While the DS method and the JG approach provide the same portfolio solution as the size of uncertainty goes to zero, else the two solutions can differ substantially. Because under the DS method portfolio holdings are never approximated in the direction of the size of uncertainty, even higher-order approximations lead to the (zero-order) constant solution in our example model. In contrast, the JG solution generally varies as the size of uncertainty changes, and already a second-order JG solution can account for effects of skewness and kurtosis of equity returns. (authors' abstract) / Series: Department of Economics Working Paper Series

Using a stylized two-period model we compare portfolio solutions from two local solution approaches - the approach of Judd and Guu (2001) and the approach of Devereux and Sutherland (2010, 2011) - with the true nonlinear portfolio solution.

We compare the performance of the perturbation-based (local) portfolio solution method of Devereux and Sutherland (2010a, 2011) with a global solution method. As a test suite we use model specifications that broadly capture features of international financial trade, between advanced economies, and between advanced and emerging economies. We consider both symmetric country setups and asymmetric setups, that capture important empirical facts such as differences in macroeconomic volatility, differences in portfolio composition, and high equity premia. We find that the local method performs well at business cycle frequencies, both in the symmetric and asymmetric settings, while significant differences arise at long horizons in asymmetric settings. (authors' abstract)