Portfolio Home Bias and External Habit Formation

Abstract

This paper challenges the consensus that hedging against real exchange rate risk is unable to account for the empirically observed level of equity home bias. I consider a general equilibrium model which features cross-country heterogeneity in conditional risk aversion, generated by the interaction of home bias in preferences and external habit formation. In equilibrium, financing home consumption entails hedging against increases in home conditional risk aversion. I show that if preferences are sufficiently home biased, an increase in home risk aversion leads to a relative appreciation of the home equity due to the impact of an endogenous, risk aversion-generated demand shock which appreciates the home good. Furthermore, the model generates realistic asset return dynamics, satisfying a long-standing need of the international finance literature.