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.