What explains equity home bias? Theory and evidence at the sector level

Abstract

This paper examines the well-known equity home bias puzzle in international finance by exploiting the cross-sector variation. Combining unique financial datasets, I introduce a novel sectoral home bias index that covers 27 industries in 43 countries, which enables empirical and theoretical analysis of the puzzle in unprecedented detail. I uncover two stylized facts (1) sectoral home bias is stronger for nontradable sectors and in countries with a higher degree of capital restrictions, and (2) investors tilt portfolios more towards domestic assets for the sectors in which their countries reveal a comparative advantage. Motivated by these findings, I build a multi-sector model that incorporates transaction costs, information asymmetry, and risk-hedging motives in investors’ portfolio choice. Moreover, I quantify the effects of these frictions on both sector- and country-level home bias in a calibrated DSGE model. This framework sheds light on the patterns and determinants of international financial investment.