Equity Home Bias Research Articles

Hedging political risk in international portfolios

We show that internationally diversified portfolios carry sizeable political risk premia and expose investors to tail risk. We obtain political efficient frontiers with and without hedging political risk using a portfolio selection model for skewed distributions and develop a new asymptotic inference test to compare portfolio performance. Politically hedged portfolios outperform a broad market index and the equally weighted portfolio for US, Eurozone, and Japanese investors. Political risk hedging is not subsumed by currency hedging, and the diversification gains of politically hedged portfolios persist under currency hedging and transaction cost frictions. Hedging political risk induces equity home bias but does not fully explain the puzzle.

Equity Home Bias in Emerging and Advanced Economies: Trend Before and During COVID-19

Equity Home Bias in Emerging and Advanced Economies: Trend Before and During COVID-19

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

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.

Equity Home Bias in a Capital Market Union

I study the social efficiency and aggregate effects of equity home bias using a general equilibrium model with nominal rigidities and a fixed exchange rate. I find that the source of home bias is key for analyzing the wedge between equilibrium and socially optimal levels of home bias. Surprisingly, when home bias is due to labor income hedging effects, stock positions tend to be approximately efficient despite the aggregate demand externalities induced by the rigidities. On the other hand, home stock positions are excessive when home bias is due to financial frictions or biased expectations. The key theoretical results hold numerically well in a more general quantitative model.

Political uncertainty and cross-border equity portfolio allocation decisions: International evidence

Political risk models highlight that political uncertainty matters for corporate investment decisions. However, how political uncertainty matters for investment allocation decisions is relatively under-explored. In this study, we examine the impact of political uncertainty associated with national elections on foreign equity portfolio in 48 countries. Our results indicate that political uncertainty reduces international equity allocations to the host country and such reduction appears more pronounced in the election year. Further analysis shows that the interaction between political uncertainty and institutional quality has a positive and significant effect on international equity portfolio flow, suggesting that the value of institutional quality outweighs the negative effects of political uncertainty. Lastly, we find equity home bias to be negative and significant; however, the interaction between political uncertainty and equity home bias appears insignificant.

Religion and Equity Home Bias

Religion and Equity Home Bias

A study on equity home bias using vine copula approach

The study investigates if the mean-downside risk optimization technique for asset allocation can shed new light on the equity home bias puzzle. We propose a combined EGARCH-EVT-C-vine copula approach to properly capture the stylized properties of asset return series and estimate the downside risk appropriately by CVaR. Using weekly stock price data from 12 countries including seven G7 countries and five BRICS countries, we estimate international portfolio allocations based on mean-CVaR optimization model and compare the results to the mean–variance allocations. The study has been done from the perspective of US investors. The results of the study suggest that the US equity home bias is overestimated by the mean–variance approach. The mean-CVaR model helps to factor in the additional risk that investors face in international portfolio diversification and provides a plausible empirical explanation for the equity home bias phenomenon. The findings of the study have direct implications for portfolio managers and investors for taking better international investment decisions based on the knowledge of optimum portfolio.

International portfolio diversification and the home bias puzzle

We review the literature on equity home bias, a phenomenon stating that investors do not hold enough foreign equities for an optimally diversified portfolio. We begin by defining the home bias measurement and reviewing related evidence on the bias. Further, we consider four explanations for this puzzling phenomenon: barriers to foreign investment, country-specific risks, information asymmetry, and cultural and behavioral factors. We analyze the related theoretical arguments and empirical findings of prior studies within each explanation. Based on the discussion of previous studies, several avenues for future research are suggested. (JEL G11, G15, F41)

Non-fundamental home bias in international equity markets

This paper examines the home bias in the international equity market using 1) the country-level behavioral factor and 2) the home-foreign return correlation. Specifically, we use responses to the question regarding the level of trust toward strangers as a measure for the behavioral factor that we call country-specific unfamiliarity. The empirical results based on the data from eleven developed countries suggest that country-specific unfamiliarity has a significant and positive correlation with the equity home bias. On the other hand, we find that the home-foreign return correlation is negatively correlated with the equity home bias, which goes against our hypothesis. We check for the robustness of our empirical analysis by fitting alternative specifications and using a log-transformed measure of the equity home bias.

The Impact of CEOs’ Social Capital on China’s Qualified Foreign Institutional Investors’ Holdings

ABSTRACT The phenomenon of underinvestment in foreign equity securities is widely acknowledged as equity home bias. Relying on China’s sociological characteristics to explain this equity home bias, this research investigates whether CEOs’ social capital is a factor affecting the investment decisions of qualified foreign institutional investors (QFIIs). The empirical results show that CEOs’ elite university network (i.e., CEOs’ elite networks from the top 2 universities in China – Peking University & Tsinghua University) are significantly negatively related to QFIIs’ holdings whereas CEOs’ political connections (i.e., CEOs’ formal position interlock & political background) are significantly positively related to QFIIs’ investment. The findings also show that QFIIs prefer to invest in cross-listed firms with higher capitalization and enhanced performance. Our research confirms the central view of social capital theory that social networks have value, but also supplements the literature by finding that social capital may have greater benefit for CEOs rather than shareholders.

What Explains Equity Home Bias? Theory and Evidence at the Sector Level

What Explains Equity Home Bias? Theory and Evidence at the Sector Level

What Explains Equity Home Bias? Theory and Evidence at the Sector Level

What Explains Equity Home Bias? Theory and Evidence at the Sector Level

Equity home bias and consumption-real exchange rate puzzles: A joint solution

In a standard dynamic stochastic general equilibrium model with a complete asset market, home agents should hold a foreign equity biased portfolio to hedge the non-traded labor income risk, which contradicts home equity biased portfolios observed worldwide. As the labor income share increases, the degree of home bias should decrease because there is more incentive to hold foreign equity. In the data, there is not any evidence that the labor income share and the degree of home bias are negatively correlated. The standard model also predicts that the consumption differential-real exchange rate correlation is positive, while it is negative in the data. I show that a combination of market incompleteness, non-tradable goods, and labor supply can explain the three features above. My model can generate a large equity home bias, despite the strong positive correlation of non-traded human capital return with domestic equity return. The home bias is not sensitive to the labor income share. The consumption differential-real exchange rate unconditional correlation generated by my model simulation is zero.

Moral Universalism: Measurement and Economic Relevance

Many applied economic settings involve trade-offs between in-group members and strangers. To better understand decision making in these contexts, this paper measures and investigates the economic relevance of heterogeneity in moral universalism: the extent to which people exhibit the same level of altruism and trust toward strangers as toward in-group members. We first introduce a new experimentally validated, survey-based measure of moral universalism that is simple and easily scalable. We then deploy this tool in a large, representative sample of the U.S. population to study heterogeneity and economic relevance. We find that universalism is a relatively stable trait at the individual level. In exploratory analyses, heterogeneity in universalism is significantly related to observables: Older people, men, the rich, the rural, and the religious exhibit less universalist preferences and beliefs. Linking variation in universalism to self-reports of economic and social behaviors, we document the following correlations. Universalists donate less money locally, but more globally, and are less likely to exhibit home bias in equity and educational investments. In terms of social networks, universalists have fewer friends, spend less time with them, and feel more lonely. These results provide a blueprint for measuring moral universalism in applied settings and suggest that variation in universalism is relevant for understanding a myriad of economic behaviors. This paper was accepted by Yan Chen, behavioral economics and decision analysis.

Wealth heterogeneity, information acquisition and equity home bias: Evidence from U.S. household surveys of consumer finance

• Equity home bias occurs along both extensive and intensive margins. • Wealthy US households are more likely to participate in the foreign stock market. • As investor wealth increases, portfolio share invested in foreign equities decreases. • Overall international diversification is increasing with wealth. • A noisy rational expectations equilibrium model with wealth heterogeneity, entry costs, and information processing can explain both margins. The well-known equity home bias has two components: an extensive and intensive margin. Using data on direct stock holdings of U.S. households, we find that the decision to participate in foreign stock markets depends on investor wealth, with richer investors more likely to participate (the extensive margin). We document a new finding: as investor wealth increases, the portfolio share invested in foreign equities tends to decrease (the intensive margin). A noisy rational expectations equilibrium model with wealth heterogeneity, entry costs, and endogenously chosen information processing capacity can generate the new negative relationship and help understand the U.S. household equity home bias along both margins.

International Portfolio Investments with Trade Networks

What determines the composition of international portfolio investments remains an open question in international finance. In this paper, I propose a theory of international portfolio choice where trade networks play a key role. I solve in closed form for the optimal equity and bond portfolio investments in a multi-country model with arbitrary global input - output linkages and taste differences. I show that a measure of international demand exposure, called the “International Domar Weights” (IDWs), is key in determining international equity portfolios. The IDWs extend the closed-economy “Domar weights” to the international setting and capture countries' interdependence through both direct and indirect trade linkages. Using data from the World Input - Output Database (WIOD) and Coordinated Portfolio Investment Survey (CPIS), I apply the framework to a network of 43 major developed and emerging economies and obtain four main results. First, the theoretical network portfolio is a significant predictor and explains almost half of the variation in international bilateral portfolio investments. The significance of the network portfolio is robust to controlling for gravity factors (market capitalization, distance, EU membership, etc.). Second, including the network-based portfolio in a gravity model for assets resolves the puzzle of why distance matters for asset trade at all. Third, indirect trade linkages matter for portfolio determination, highlighting the need to explicitly account for trade in intermediate inputs. Finally, the model predicts both the levels and the changes in equity home bias that have occurred since 2000.

Explaining equity home bias using hedging motives against real exchange rate and wage risks

This paper derives an optimal portfolio equilibrium using a two-country DSGE model with non-separable utility and two assets (home and foreign equities). We solve the model using a second-order approximation method, which enables us to derive a closed-form solution for optimal equity holdings. When the elasticity of substitution between home and foreign goods is below around 1.2, the covariance between wage and equity return becomes negative and the covariance between price and equity return becomes positive. In this case, home equity provides hedging against wage and real exchange rate risks and optimal portfolio equilibrium shows a home bias. In addition, we show that equity holding bias (either home or foreign) is amplified under separable utility case, implying that previous studies with separable utility may have overestimated equity holding bias.

Equity Home Bias When Firms are Indebted

We reassess one of the major puzzles in international macroeconomics, namely the equity home bias puzzle, to shed some light on how it is affected by financial leverage. As corporate debt is generally key to employment, the analysis can provide interesting insights to the mooted argument according to which equity home bias stems from agents’ attempt to insure against changes in their labor income. In a panel of advanced economies spanning the period 1980 through 2018, we find that the non-financial corporate credit-to-GDP ratio is negatively correlated with a standard equity home bias index. The former has increased over time while the latter has decreased, so we attempt to rationalize the data with a two-country, two-good model where firms face borrowing constraints and these constraints reduce agents’ appetite for domestic equities. We show that this happens because the borrowing constraints hinder employment after positive technology shocks, especially those hitting investment. After examining this result with a tractable framework, we find that it can also be true in an extended model, adding financial shocks, trade in bonds and non-unitary elasticity of substitution between goods.

Managing Political Risk in International Portfolios

We show that internationally diversified portfolios carry sizeable political risk premia. Using a portfolio selection model with tail risk, we obtain political efficient frontiers from skewed return distributions to manage political risk, and design an inference test to draw conclusions. We find that politically hedged international portfolios of US investors realize performance gains against a broad market index (and other benchmarks). Currency hedging does not eliminate political risk. The diversification gains increase for long-horizon investors. Qualitatively identical results are obtained for Eurozone and Japan. Our findings inform the home equity bias puzzle literature, and are robust to several model specifications.

Long-term implications of oil discoveries for international saving in a DSGE model

Possession and production of oil reserves affects the host country’s current account. Throughout the history of the North Sea oil, Norway ran persistent current account surpluses and accumulated public “oil funds.” The other major producer, the United Kingdom did not establish an oil fund. This work models how oil discoveries impact the current account. A small open economy DSGE model with an oil sector expresses the current account as a function of oil discoveries. In this model, an oil discovery creates a long-term borrowing-repayment-saving cycle. Some of the characteristics of the economy that affect oil-related decisions include: the presence of an oil fund, the equity home bias, and the technology of the oil industry. These characteristics are estimated structurally using the North Sea data for Norway and the United Kingdom. The estimation suggests that, upon discovering oil in the North Sea, the populations of Norway and the United Kingdom made similar economic choices but under different circumstances: Norway’s export revenues were amplified by a period of high oil prices in the 2000s, whereas the UK largely balanced its oil trade and did not benefit from the oil price. Similar decisions made under different circumstances led to remarkably different effects of oil discoveries on the current accounts.