Equity Home Bias Research Articles

The Effects Of Restricting Capital Outflows On Investment In An Open Economy

<p class="MsoBodyText2" style="text-align: justify; line-height: normal; margin: 0in 34.2pt 0pt 0.5in;"><span style="font-size: 10pt;"><span style="font-family: Times New Roman;">This paper considers the effects of restricting capital outflows on foreign investment in a developing country. It is shown that a developing country may restrict capital outflows if domestic economic conditions are poor, and it may liberalize capital outflows if domestic economic conditions are strong. Restricting capital outflows has large impact if the investment horizon is short. Furthermore, restricting capital outflows may discourage foreign investors from investing in the developing country. This result is consistent with the home equity bias.</span></span></p>

The Impact of International Portfolio Composition on Consumption Risk-Sharing

Recent empirical work has shown that ongoing international financial integration facilitates cross-country consumption risk-sharing. These studies typically find that countries with high equity home bias exhibit relatively low international consumption risk sharing. We extend this line of research and demonstrate that it is not only a country’s equity home bias that prevents consumption risk sharing. In addition, the composition of a country’s foreign asset portfolio plays an important role. Using panel-data regression for a group of OECD countries over the period 1980-2007, we show that foreign investment bias has additional explanatory power for consumption risk sharing.

A New Open Economy Macroeconomic Model with Endogenous Portfolio Diversification and Firms Entry

This paper provides a new benchmark for the analysis of the international diversification puzzle in a tractable new open economy macroeconomic model. Building on Cole and Obstfeld (1991) and Heathcote and Perri (2009), this model specifies an equilibrium model of perfect risk sharing in incomplete markets, with endogenous portfolios and number of varieties. Equity home bias may not be a puzzle but a perfectly optimal allocation for hedging risk. In contrast to previous work, the model shows that: (i) optimal international portfolio diversification is driven by home bias in capital goods, independently of home bias in consumption, and by the share of income accruing to labour. The model explains reasonably well the recent patterns of portfolio allocations in developed economies; and (ii) optimal portfolio shares are independent of market dynamics.

When Bonds Matter: Home Bias in Goods and Assets

This paper presents a model of international portfolios with real exchange rate and non financial risks that accounts for observed levels of equity home bias. A key feature is that investors can trade equities as well as domestic and foreign real bonds. Bonds matter: in equilibrium, investors structure their bond portfolio to hedge real exchange rate risk since relative bond returns are strongly correlated with real exchange rate movements. Equity home bias does not arise from the co-movements between relative stock returns and real exchange rates, but from the hedging properties of stock returns against other sources of risk, conditionally on bond returns. We estimate the optimal equity and bond portfolios implied by the model for G-7 countries and find strong empirical support for the theory. We are able to account for a significant share of the equity home bias and obtain a currency exposure of bond portfolios comparable to the data.

The Role of Transaction Costs vs. Information Costs in Explaining the Equity Home Bias Puzzle: Empirical Evidence from Euronext

The Role of Transaction Costs vs. Information Costs in Explaining the Equity Home Bias Puzzle: Empirical Evidence from Euronext

Who Invests in Home Equity to Exempt Wealth from Bankruptcy?

Homestead exemptions to personal bankruptcy allow households to retain their home equity up to a limit determined at the state level. Households that may experience bankruptcy thus have an incentive to bias their portfolios towards home equity. Using US household data from the Survey of Income and Program Participation for the period 1996-2006, we find that especially households with low net worth maintain a larger share of their wealth as home equity if a larger homestead exemption applies. This home equity bias is also more pronounced if the household head is in poor health, increasing the chance of bankruptcy on account of unpaid medical bills. The bias is further stronger for households with mortgage finance, shorter house tenures, and younger household heads, which taken together reflect households that face more financial uncertainty.

International portfolio diversification is better than you think

Using aggregate data on bilateral cross-border equity holdings, we investigate whether investors correctly hedge their over-exposure to domestic risk (the well-known equity home bias) by investing in foreign stock markets that have low correlation with their home stock market. To deal with the endogeneity of stock return correlations, we instrument current correlations with past correlations. Controlling for many determinants of international portfolios, we find that, all else equal, investors do tilt their foreign holdings towards countries, which offer better diversification opportunities. The diversification motive that we uncover is stronger for source countries exhibiting a higher level of home bias.

Local Analyst Earnings Forecast Advantages in Europe

This study investigates local analyst earnings forecast advantages in Europe. Information asymmetries or different incentives may drive hypothesized local advantages. Statistically significant, but not overwhelming, evidence indicates that local analysts forecast earnings more accurately than non-local analysts. Leader and follower tests support the observation that local analysts issue timelier forecasts. Accuracy results are driven in part by the German sample and may be attributable to the DVFA/SG earnings adjustment process used by analysts. U.K. (London) based analysts are less accurate forecasters. The magnitude of the local forecast advantage is large enough to be economically interesting, particularly in Germany. The findings support the existence of geographic information asymmetries and support explanations for home equity bias.

Australia’s equity home bias and real exchange rate volatility

The main purpose of this paper is to consider the effect of real exchange rate volatility on equity investment by Australian investors. Equity investment is of major importance to savers and investors in Australia. Also real exchange rate volatility is an important influence on Australia’s financial integration in the global economy. Analysis of the effect of real exchange rate volatility on Australia’s equity home bias is important since Australian dollar is a commodity currency. There is a close relationship between Australia’s terms of trade and real exchange rate volatility. Home bias is measured on the basis of free float-adjusted market capitalization in recognition of the fact that closely held shares are not available to ordinary investors. Real exchange rate volatility is measured by deviations from purchasing power parity on a bilateral basis between Australia and 35 countries. The cross-border equity investment data over the period 2001–2007 are from International Monetary Fund’s Coordinated Portfolio Investment Survey. Australian investors are found to invest significantly less in a country if the real exchange rate volatility of that country is relatively high (results that are robust to standard control measures and generalized method of moments).

Channels of international risk-sharing: capital gains versus income flows

Global financial integration unlocks a huge potential for international risk sharing. We examine the degree to which international equity holdings act as a risk sharing device in industrial and emerging economies. We split equity returns into investment income (dividend distribution) and capital gains to investigate which of the two channels delivers the largest potential for risk sharing. Our evidence suggests that net capital gains are a more potent channel of risk sharing. They behave in a countercyclical way, that is they tend to be positive (negative) when the domestic economy is growing more slowly (rapidly) than the rest of the world. Countries with more countercyclical net capital gains experience improved consumption risk sharing. The empirical analysis furthermore suggests that these risk sharing properties of net capital gains have increased through time, in particular in the 1990s and early-2000s, on the back of a declining equity home bias and financial market deepening.

Equity home bias in Australian superannuation funds

Equity home bias for Australia superannuation funds is examined under a model that reflects observed decision processes. The mix of Australian and international equities is evaluated as a two-asset choice under the influence of legacy, an objective function that trades off expected returns against portfolio risk and peer risk, and under expectations that are formed adaptively and allow for taxation differences. The model closely replicates the observed equity mix, particularly relative to more traditional mean-variance formulations. The main implication is that home bias may be better explained under models that reflect industry practices and allow for various commingled influences. JEL classifications G11, G23

Regime Switching, Asymmetric Correlation and International Portfolio Choices

The aim of this paper is to investigate the behavior of international equity returns and correlations using the discrete-time Markov-switching model and the impact of this behavior on international portfolio choices. We take the perspective of a US-based global investor who considers investment across the six largest major markets over the period from December 1994 to July 2009. Results show that financial markets are characterized by two regimes: a bull and a bear markets. Besides, correlations appear to be very important in a bear state and significantly different than those in bull market. Finally, optimal portfolio weights vary considerably across regimes and over time as investors revise their estimates of the state probabilities. For a degree of risk aversion equal to three, the optimal weight of domestic asset is equal to 100% in a bear regime. Thus, the presence of regime in the equity return distributions turns out to play important roles in the U.S. investors’ international portfolio choices. Therefore, it helps to explain the home equity bias.

Global Public Signals, Heterogeneous Beliefs, and Stock Markets Comovement

We build an information-based two-country general equilibrium model. There are two dividend processes with correlated growth rates. Agents observe a global public signal informative about both growth rates. We first let agents rationally process information, and then we allow for reasonable departures from rationality. That is, agents are overconfident with respect to the signal, and thus have heterogeneous beliefs. We report a significant increase in comovement between stock returns. Moreover, we find that a small amount of misinterpretation of the global signal is sufficient to generate sizable comovement, as compared to the benchmark case of rational expectations. As an additional implication of overconfidence, we show that our model is able to produce a substantial home equity bias.

The puzzling evolution of the home bias, information processing and financial openness

This paper explains the home equity bias and its puzzling evolution in a model where investors face an information constraint and have an initial local informational advantage. After financial liberalization, local investors have a magnified informational advantage since information processed under autarky remains useful after liberalization. A gradual shift towards foreign assets occurs as the relevance of autarkic information declines over time. In the long run, home bias remains large due to the interaction between information and portfolio choices. Empirical evidence supports the main predictions of our model, namely that bias increases with information capacity and decreases with financial openness.

Investor Protection, Equity Returns, and Financial Globalization

AbstractWe study the effects of investor protection on stock returns and portfolio allocation decisions. In our theoretical model, if investor protection is weak, wealthy investors have an incentive to become controlling shareholders. In equilibrium, the stock price reflects the demand from both controlling shareholders and portfolio investors. Due to the high demand from controlling shareholders, the price of weak corporate governance stocks is not low enough to fully discount the extraction of private benefits. Thus, stocks have lower expected returns when investor protection is weak. This has implications for domestic and foreign investors’ stockholdings. In particular, we show that portfolio investors’ participation in the domestic stock market and home equity bias are positively related to investor protection and provide original evidence in their support.

Endogenous Acquisition of Information and the Equity Home Bias

This paper investigates the extent to which differences in information costs can explain the equity home bias puzzle. In a model where information costs are higher for the Foreign asset than for the Home asset, I show that, if cost functions are convex and the assets have identical return characteristics, the expected size of the home bias in terms of differences in expected demands is positive and increasing in expected excess returns and risk, but decreasing in risk aversion. However, a calibration to US data suggests that information costs can explain only a small fraction of the observed home bias.

International portfolios, capital accumulation and foreign assets dynamics

Despite the liberalization of capital flows among OECD countries, equity home bias remains sizable. We depart from the two familiar explanations of equity home bias: transaction costs that impede international diversification, and terms of trade responses to supply shocks that provide risk sharing, so that there is little incentive to hold diversified portfolios. We show that the interaction of the following ingredients generates a realistic equity home bias: capital accumulation and international trade in stocks and bonds. In our model, domestic stocks are used to hedge fluctuations in local wage income. Terms of trade risk is hedged using bonds denominated in local goods and in foreign goods. In contrast to related models, the low level of international diversification does not depend on strongly countercyclical terms of trade. The model also reproduces the cyclical dynamics of foreign asset positions and of international capital flows.

International capital mobility: linking the Feldstein-Horioka puzzle to the trade and equity home bias puzzles

We revisit the Feldstein-Horioka (FH) puzzle using data for 23 Organisation for Economic Co-operation and Development (OECD) countries for the period 1973-2003. We document a sharp decline in the FH coefficient from the mid-1990s onward, supporting the hypothesis of increased economic and financial integration. Subsequently, we extend the literature and use a non-linear specification with interaction terms to empirically show that observed decreases in equity home bias (EHB) and increases in trade openness are structurally linked to the time variation in the FH coefficient. Thus, this paper empirically establishes a structural link between three puzzles in international macroeconomics and finance: the FH puzzle, the EHB puzzle and the trade home bias puzzle.

Asymmetric Information, Portfolio Managers and Home Bias

Why do investors excessively tilt their portfolio towards domestic assets? Recent studies suggest asymmetric information plays a significant role in the home equity bias puzzle. A key assumption in theoretical models is that agents invest in assets and process information on their own. However, most international investments are executed by managers in financial institutions. These institutions allocate significant resources to processing information, making the asymmetric information assumption less appealing. In this paper, we explain home bias at the fund level by showing how information asymmetry at the individual level has relevant implications at the portfolio management level. Agents delegate their investment decisions to portfolio managers of different and uncertain ability. Investors are better informed about the performance of domestic markets; and therefore, are more able to evaluate the ability of managers operating in these markets. This, in turn, makes investing in domestic markets less risky and attracts more managers. Additionally, highly skilled managers benefit more from higher transparency, and this is why they are more likely to choose to operate in the domestic market. Therefore, a small information asymmetry of individual investors generates home bias due to highly skilled managers in the domestic market (higher than in the foreign market) and diversification (a higher number of managers in the domestic market). We simulate the model and find that on average 69.2% of investment is in the domestic market.

International Portfolio Allocation under Model Uncertainty

This paper revisits an old argument, hedging real exchange rate risk, as an explanation of the international home bias in equity. In a dynamic model, the relevant risk to be hedged is the long-run risk as opposed to the short-run risk. Domestic equity is indeed a good hedge with respect to long-run real-exchange-rate risk. Two new frameworks are able to explain a large share of the observed US home bias: a model with Hansen-Sargent preferences in which agents fear model misspecification and a model with Epstein-Zin preferences. These two models are also immune to the risk-free rate puzzle. (JEL C58, F31, G11, G15)