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Understanding International Portfolio Diversification and Turnover Rates

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  • Amir Amadi
  • Paul Bergin

Abstract

This paper argues that fixed trading costs in international asset markets help explain equity home bias. This contrasts with explanations prevalent in international macroeconomics, which tend to be based on trading frictions instead in international goods markets, such as nontraded goods or transportation costs. While the stylized fact of high trading turnover in foreign holdings has been interpreted as evidence against international asset trading costs, we show that this argument only applies to costs that are proportional to trade, and not to fixed costs of entering the foreign market. After documenting that the home bias and turnover stylized facts remain valid in recent data, the paper constructs a very simple portfolio allocation model with various configurations of trading costs and with heterogeneous types of traders. A configuration with per unit costs heterogeneous among agents and a homogeneous fixed cost is found to replicate the pair of stylized facts. Intuitively, the lower trading costs that characterize larger and more efficient traders have two implications: firstly, these traders find it more profitable to enter foreign markets; secondly, their lower trading costs encourage a higher rate of trading turnover. Since holdings of international equities are disproportionately dominated by this class of larger and more efficient traders, average trading turnover is higher among international holdings.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12473.

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Date of creation: Aug 2006
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Publication status: published as Amadi, Amir A. & Bergin, Paul R., 2008. "Understanding international portfolio diversification and turnover rates," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 18(2), pages 191-206, April.
Handle: RePEc:nbr:nberwo:12473

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  1. Kenneth R. French & James M. Poterba, 1991. "Investor Diversification and International Equity Markets," NBER Working Papers 3609, National Bureau of Economic Research, Inc.
  2. Wincoop, Eric van, 1994. "Welfare gains from international risksharing," Journal of Monetary Economics, Elsevier, vol. 34(2), pages 175-200, October.
  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. Merton, Robert C, 1987. " A Simple Model of Capital Market Equilibrium with Incomplete Information," Journal of Finance, American Finance Association, vol. 42(3), pages 483-510, July.
  5. Martin, Philippe & Rey, H., 2000. "Financial integration and asset returns," European Economic Review, Elsevier, vol. 44(7), pages 1327-1350, June.
  6. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," International Trade 0012003, EconWPA.
  7. Heathcote, Jonathan & Perri, Fabrizio, 2004. "Financial globalization and real regionalization," Journal of Economic Theory, Elsevier, vol. 119(1), pages 207-243, November.
  8. Mark Grinblatt, 2001. "How Distance, Language, and Culture Influence Stockholdings and Trades," Journal of Finance, American Finance Association, vol. 56(3), pages 1053-1073, 06.
  9. Philip R. Lane & G.M. Milesi-Ferretti, 2003. "International Financial Integration," Trinity Economics Papers 20031, Trinity College Dublin, Department of Economics.
  10. Andrew B. Bernard & J. Bradford Jensen, 2004. "Why Some Firms Export," The Review of Economics and Statistics, MIT Press, vol. 86(2), pages 561-569, May.
  11. Pesenti, Paolo & van Wincoop, Eric, 2002. "Can Nontradables Generate Substantial Home Bias?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(1), pages 25-50, February.
  12. Joshua Aizenman, 1999. "International Portfolio Diversification with Generalized Expected Utility Preferences," Canadian Journal of Economics, Canadian Economics Association, vol. 32(4), pages 995-1008, August.
  13. Patrick F. Rowland & Linda L. Tesar, 1998. "Multinationals and the Gains from International Diversification," NBER Working Papers 6733, National Bureau of Economic Research, Inc.
  14. 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.).
  15. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
  16. Rowland, Patrick F., 1999. "Transaction costs and international portfolio diversification," Journal of International Economics, Elsevier, vol. 49(1), pages 145-170, October.
  17. Warnock, Francis E., 2002. "Home bias and high turnover reconsidered," Journal of International Money and Finance, Elsevier, vol. 21(6), pages 795-805, November.
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Cited by:
  1. Dimitrios Christelis & Dimitris Georgarakos, 2008. "Investing at Home and Abroad: Different Costs, Different People?," CSEF Working Papers 188, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy, revised 10 Jan 2013.
  2. Jonathan Heathcote & Fabrizio Perri, 2004. "The international diversification puzzle is not as bad as you think," 2004 Meeting Papers 152, Society for Economic Dynamics.
  3. Nicolas Coeurdacier & Hélène Rey, 2013. "Home Bias in Open Economy Financial Macroeconomics," Journal of Economic Literature, American Economic Association, vol. 51(1), pages 63-115, March.
  4. Arie Kapteyn & Federica Teppa, 2009. "Subjective Measures of Risk Aversion, Fixed Costs, and Portfolio Choice," DNB Working Papers 216, Netherlands Central Bank, Research Department.
  5. Ni, Jinlan, 2009. "The effects of portfolio size on international equity home bias puzzle," International Review of Economics & Finance, Elsevier, vol. 18(3), pages 469-478, June.
  6. repec:spo:wpecon:info:hdl:2441/c8dmi8nm4pdjkuc9g81p7j6b6 is not listed on IDEAS
  7. Hnatkovska, Viktoria, 2010. "Home bias and high turnover: Dynamic portfolio choice with incomplete markets," Journal of International Economics, Elsevier, vol. 80(1), pages 113-128, January.

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