Consumption hedging and home‐country bias in a model of international capital market equilibrium

Abstract

PurposeThe purpose of this paper is to develop a model of international capital market equilibrium where investors exhibit home‐country bias due to their desire to hedge real consumption.Design/methodology/approachThis paper posits a two‐stage process of portfolio choice for the representative investor of a country. In the first step, the investor's benchmark portfolio is determined, whereas in the second step, his optimal portfolio is chosen. The latter portfolio maximizes the expected portfolio rate of return minus the risk tolerance weighted variance of tracking error. The market equilibrium implications of the portfolio optimality conditions are determine via aggregation across all investors and countries.FindingsA revised security market line is derived that differs from the traditional security market line in terms of vertical intercept, slope, and beta coefficient. It is demonstrated that the derived model may be interpreted as a multi‐country generalization of the Chen‐Boness extension of the capital asset pricing model under uncertain inflation.Originality/valueThis paper presents an innovative application of Roll's tracking portfolio paradigm. Another novel feature is the derivation of the international capital market equilibrium implications of such portfolio choice behaviour.