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A Rational Explanation For Home Country Bias

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  • Iftekhar Hasan
  • Yusif Simaan

Abstract

While modern portfolio theory predicts that investors should diversify across international markets, corporate equity is essentially held by domestic investors. French and Poterba (1991) suggest that in order for this bias to be justified, investors must hold optimistic expectations about their domestic markets and pessimistic expectations about their foreign markets. Tesar and Werner (1995) find existing explanations to the home equity bias unsatisfactory and conclude that the issue poses a challenge for portfolio theory. We develop a model that incorporates both the foregone gains from diversification and the informational constraints of international investing, and shows that home equity bias is consistent with rational mean-variance portfolio choice. Specifically, we prove that the nature of estimation risk in international markets can be responsible for this phenomenon. We show that when the cross-market variability in the estimation errors of international markets' means far exceeds the cross-market variability in the means themselves, domestic dedication dominates international diversification. An examination of eleven international markets' returns over the last twenty-five years, from the perspective of German, Japanese and U.S investors provides evidence consistent with this explanation.

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Bibliographic Info

Paper provided by New York University, Leonard N. Stern School of Business- in its series New York University, Leonard N. Stern School Finance Department Working Paper Seires with number 99-067.

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Date of creation: 1999
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Handle: RePEc:fth:nystfi:99-067

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  1. Jorion, Philippe, 1985. "International Portfolio Diversification with Estimation Risk," The Journal of Business, University of Chicago Press, vol. 58(3), pages 259-78, July.
  2. Cutler, David M & Poterba, James M & Summers, Lawrence H, 1991. "Speculative Dynamics," Review of Economic Studies, Wiley Blackwell, vol. 58(3), pages 529-46, May.
  3. Tesar, Linda L. & Werner, Ingrid M., 1995. "Home bias and high turnover," Journal of International Money and Finance, Elsevier, vol. 14(4), pages 467-492, August.
  4. Yusif Simaan, 1993. "What is the Opportunity Cost of Mean-Variance Investment Strategies?," Management Science, INFORMS, vol. 39(5), pages 578-587, May.
  5. Levy, Haim & Sarnat, Marshall, 1970. "International Diversification of Investment Portfolios," American Economic Review, American Economic Association, vol. 60(4), pages 668-75, September.
  6. French, Kenneth R & Poterba, James M, 1991. "Investor Diversification and International Equity Markets," American Economic Review, American Economic Association, vol. 81(2), pages 222-26, May.
  7. Jun-Koo Kang & Rene M. Stulz, 1995. "Why Is There a Home Bias? An Analysis of Foreign Portfolio Equity Ownership in Japan," NBER Working Papers 5166, National Bureau of Economic Research, Inc.
  8. John L. G. Board & Charles M. S. Sutcliffe, 1994. "Estimation Methods in Portfolio Selection and the Effectiveness of Short Sales Restrictions: UK Evidence," Management Science, INFORMS, vol. 40(4), pages 516-534, April.
  9. West, Kenneth D. & Edison, Hali J. & Cho, Dongchul, 1993. "A utility-based comparison of some models of exchange rate volatility," Journal of International Economics, Elsevier, vol. 35(1-2), pages 23-45, August.
  10. Cooper, Ian & Kaplanis, Evi, 1994. "Home Bias in Equity Portfolios, Inflation Hedging, and International Capital Market Equilibrium," Review of Financial Studies, Society for Financial Studies, vol. 7(1), pages 45-60.
  11. Morris Goldstein & Michael Mussa, 1993. "The Integration of World Capital Markets," IMF Working Papers 93/95, International Monetary Fund.
  12. Harvey, Campbell R, 1991. " The World Price of Covariance Risk," Journal of Finance, American Finance Association, vol. 46(1), pages 111-57, March.
  13. Dumas, Bernard & Solnik, Bruno, 1995. " The World Price of Foreign Exchange Risk," Journal of Finance, American Finance Association, vol. 50(2), pages 445-79, June.
  14. Robert R. Grauer and Nils H. Hakansson., 1987. "Gains from International Diversification: l968-85 Returns on Portfolios of Stocks and Bonds," Research Program in Finance Working Papers 168, University of California at Berkeley.
  15. Ferson, Wayne E & Harvey, Campbell R, 1993. "The Risk and Predictability of International Equity Returns," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 527-66.
  16. George J. Stigler, 1961. "The Economics of Information," Journal of Political Economy, University of Chicago Press, vol. 69, pages 213.
  17. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
  18. Geert Bekaert & Robert J. Hodrick, 1991. "Characterizing Predictable Components in Excess Returns on Equity and Foreign Exchange Markets," NBER Working Papers 3790, National Bureau of Economic Research, Inc.
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  1. Postino, Transener y la racionalidad acotada!
    by Elemaco in Economista Serial Crónico on 2007-02-16 21:11:00
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Cited by:
  1. Gau, Yin-Feng & Hua, Mingshu & Wu, Wen-Lin, 2010. "International asset allocation for incompletely-informed investors," Journal of Financial Markets, Elsevier, vol. 13(4), pages 422-447, November.
  2. Shujing Li & Hamid Faruqee & Isabel K. Yan, 2004. "The Determinants of International Portfolio Holdings and Home Bias," IMF Working Papers 04/34, International Monetary Fund.
  3. Hasan, Iftekhar & Malkamaki, Markku, 2001. "Are expansions cost effective for stock exchanges? A global perspective," Journal of Banking & Finance, Elsevier, vol. 25(12), pages 2339-2366, December.
  4. Barron, John M. & Ni, Jinlan, 2008. "Endogenous asymmetric information and international equity home bias: The effects of portfolio size and information costs," Journal of International Money and Finance, Elsevier, vol. 27(4), pages 617-635, June.
  5. Piti Disyatat & Gaston Gelos, 2001. "The Asset Allocation of Emerging Market Mutual Funds," IMF Working Papers 01/111, International Monetary Fund.
  6. Mishra, Anil, 2013. "Measures of Equity Home Bias Puzzle," MPRA Paper 51223, University Library of Munich, Germany.
  7. Michael R. King & Dan Segal, 2004. "International Cross-Listing and the Bonding Hypothesis," Working Papers 04-17, Bank of Canada.
  8. Campbell, Rachel A. & Kraussl, Roman, 2007. "Revisiting the home bias puzzle: Downside equity risk," Journal of International Money and Finance, Elsevier, vol. 26(7), pages 1239-1260, November.
  9. Charles Engel & Akito Matsumoto, 2006. "Portfolio Choice in a Monetary Open-Economy DSGE Model," NBER Working Papers 12214, National Bureau of Economic Research, Inc.
  10. Liliane Karlinger, 2002. "The Impact of Common Currencies on Financial Markets: A Literature Review and Evidence from the Euro Area," Working Papers 02-35, Bank of Canada.
  11. Bellalah, Makram & Aboura, Sofiane, 2003. "The effect of asymmetric information and transaction costs on asset pricing: theory and tests," Economics Papers from University Paris Dauphine 123456789/9772, Paris Dauphine University.
  12. Berrill, Jenny & Kearney, Colm, 2010. "Firm-level internationalisation and the home bias puzzle," Journal of Economics and Business, Elsevier, vol. 62(4), pages 235-256, July.

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