Government Debt and International Portfolio Diversification

Abstract

An explanation for the widely-observed phenomenon of home country asset preference is provided by the existence of government debt. Domestic government debt implies future taxes for domestic residents. Since no market exists for the statutory obligation to pay taxes, the present value of future tax payments needed to finance government debt is viewed as a nontraded asset (or liability). Because there is a positive covariation in the return on the domestic bond with the government debt liability, holding the domestic bond reduces the variation in the return on domestic residents' traded plus nontraded, or total wealth. For this reason, risk-averse domestic assetholders are shown to increase the amount of traded wealth they hold in domestic government bonds as domestic government debt increases.