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Equity home bias: Can information cost explain the puzzle?

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  • Karsten Jeske
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    Abstract

    Most stock market investors believe that the ideal equity portfolio should be well diversified to lower overall portfolio risk. International financial markets offer a means for diversification, but most investors do not exploit this risk-sharing opportunity and instead hold large shares of their portfolios in domestic stocks-a tendency called home bias. ; To measure how severe home bias is, the author introduces a method of quantifying it. A simple asset allocation model is used to determine the shadow cost of foreign investment-that is, the perceived annual cost of foreign equity necessary to create a bias away from perfect international risk sharing and toward domestic equity. The model shows that in most industrialized nations the shadow costs would have to be unrealistically high to account for home bias. In the United States the home bias is almost 150 basis points per year, by far the lowest among all industrialized nations. ; The article then discusses a popular explanation for home bias: information cost. This theory argues that investors face lower costs for gathering information on their domestic assets than on foreign assets and are therefore biased toward holding domestic equity. While this explanation is intuitive, the author demonstrates, using both a naive model and a rational expectations model, that the theory is unable to account for observed patterns of home bias. The author thus concludes that home bias is still a puzzle.

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    Bibliographic Info

    Article provided by Federal Reserve Bank of Atlanta in its journal Economic Review.

    Volume (Year): (2001)
    Issue (Month): Q3 ()
    Pages: 31-42

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    Handle: RePEc:fip:fedaer:y:2001:i:q3:p:31-42:n:v.86no.3

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    Keywords: International finance ; Capital movements ; Stock market ; Investments; Foreign;

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    1. Alan G. Ahearne & William L. Griever & Francis E. Warnock, 2000. "Information costs and home bias: an analysis of U.S. holdings of foreign equities," International Finance Discussion Papers 691, Board of Governors of the Federal Reserve System (U.S.).
    2. Maurice Obstfeld & Kenneth Rogoff, 2000. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," NBER Working Papers 7777, National Bureau of Economic Research, Inc.
    3. Robert C. Merton, 1980. "On Estimating the Expected Return on the Market: An Exploratory Investigation," NBER Working Papers 0444, National Bureau of Economic Research, Inc.
    4. Sanford J Grossman & Joseph E Stiglitz, 1997. "On the Impossibility of Informationally Efficient Markets," Levine's Working Paper Archive 1908, David K. Levine.
    5. French, Kenneth R. & Poterba, James M., 1990. "Japanese and U.S. cross-border common stock investments," Journal of the Japanese and International Economies, Elsevier, vol. 4(4), pages 476-493, December.
    6. Gehrig, Thomas, 1993. " An Information Based Explanation of the Domestic Bias in International Equity Investment," Scandinavian Journal of Economics, Wiley Blackwell, vol. 95(1), pages 97-109.
    7. Akerlof, George A, 1970. "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, MIT Press, vol. 84(3), pages 488-500, August.
    8. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, 09.
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