Bilateral Home Bias: New Perspective, New Findings

Abstract

While it is generally agreed that international diversification improves portfolio performance, many countries hold puzzling low levels of foreign assets. The difference between optimal and observed (far too low) foreign holdings is known as the home bias puzzle (see French & Poterba, 1991). The academic literature has proposed several possible explanations for the home bias puzzle. The prime targets were transaction costs such as fees, commissions and higher spreads (see Glassman & Riddick, 2001; Tesar & Werner, 1995; Warnock, 2001) and direct barriers to international investment (see Black, 1974; Errunza & Losq, 1985; Stulz, 1981). Evidence in Tesar & Werner (1995) and more recently Glassman & Riddick (2001) and Warnock (2001), however, rules out transaction cost as an important driver of the equity home bias. Moreover, the home bias puzzle persists even in times when most direct obstacles to foreign investment have disappeared. Important contributions focus on differences in the amount and quality of information between domestic and foreign stocks (see Brennan & Cao, 1997; Gehrig, 1993; Veldkamp & Van Nieuwerburgh, 2006), on hedging of non-traded goods consumption as a motive for holding domestic securities (see Adler & Dumas, 1983; Cooper & Kaplanis, 1994; Stockman & Dellas, 1989), and more recently on psychological or behavioral factors (see Coval & Moskowitz, 1999; Grinblatt & Keloharju, 2000; Huberman, 2001). However, also these alternative explanations do not fully account for the observed home bias in international financial markets (see Ahearne et al., 2004, among others). A relatively new surge in cross-border equity holdings works towards narrowing the gap and the documented decline in home bias (see Baele et al., 2007) suggests that countries are taking steps towards optimizing their international equity portfolios. Until recently, available data only allowed for a comparison between domestic equity holdings and (aggregated) rest-of-the-world foreign holdings. The International Monetary Fund’s Coordinated Portfolio Investment Survey (CPIS) collects information regarding the foreign equity holdings of 74 countries and territories, detailed by issuing country. Fidora et al. (2007) use this database available for the years 1997, 2001, 2002 and 2003 in order to compute bilateral home bias and show the contribution of real exchange volatility to explaining the well-known preference for local assets. This chapter combines the (increasingly extensive) CPIS database for the period 2001-2009 to compute bilateral home bias together with a new perspective on optimal investment benchmarks in order to explore the dynamics of bilateral home bias and the importance of