Abstract
We study the implications of human capital hedging for international portfolio choice. First, we document that, at the household level, the degree of home country bias in equity holdings is increasing in the labor income to financial wealth ratio. Second, we show that a heterogeneous agent model in which households face short selling constraints and labor income risk, calibrated to match both micro and macro labor income and asset returns data, can both rationalize this finding and generate a large aggregate home country bias in portfolio holdings. Third, we find that the empirical evidence supporting the belief that the human capital hedging motive should skew domestic portfolios toward foreign assets, is driven by an econometric misspecification rejected by the data.
Highlights
International finance theory emphasizes the effectiveness of global portfolio diversification strategies for cash-flow stabilization and consumption risk sharing.1 the empirical evidence on international portfolio holdings favors a widespread lack of diversification across countries and a systematic bias toward home country assets (see, e.g., Coeurdacier and Rey (2013) for a recent survey)
To avoid the curse of dimensionality of numerical solutions and, most importantly, in order to have sufficiently long time series for the estimation of the variance covariance matrix of labor income innovations and asset returns using the unrestricted vector autoregression (VAR) approach presented in Section III below, we focus on four countries: the United States, the United Kingdom, Japan, and Germany
This paper shows that human capital risk can help rationalize the home country bias in equity holdings at both the aggregate and household levels
Summary
International finance theory emphasizes the effectiveness of global portfolio diversification strategies for cash-flow stabilization and consumption risk sharing. the empirical evidence on international portfolio holdings favors a widespread lack of diversification across countries and a systematic bias toward home country assets (see, e.g., Coeurdacier and Rey (2013) for a recent survey). The main findings of this calibration exercise are that a) investors that enter the stock market with a low levels of liquid (i.e. financial) wealth to labor income ratio will initially specialize in domestic assets and, b) only as the level of asset wealth to labor income ratio increases do agents start diversifying their portfolios internationally by progressively adding different assets to their holdings, c) as a consequence, the aggregate portfolio of U.S investors shows a large degree of home bias. The simple incomplete markets model presented below is a generalization of Heaton and Lucas (1997) to a multiple asset context and of Michaelides (2003), and builds upon the household income process estimate by Gourinchas and Parker (2002)
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