Asymmetric Information and the Lack of International Portfolio
AbstractThere is pervasive evidence that individuals invest primarily in domestic assets and thus hold poorly diversified portfolios. Empirical studies suggest that informational asymmetries may play a role in explaining the bias towards domestic assets. In contrast, theoretical studies based on asymmetric information fail to produce significant quantitative effects. The present paper develops a theoretical model in which the presence of informational asymmetries explains a significant fraction of the home equity bias observed in the data. The main departure from previous theoretical work is the assumption that local investors outperform foreign investors in identifying the correct ranking of local investment opportunities instead of possessing superior information about the aggregate performance of the domestic stock market. The other key assumption is based on the evidence that short-selling is a costly activity. This paper studies the case of a two-country world. There are two assets in each country. Only local investors receive informative signals about local assets. Thus, domestic agents have an incentive to concentrate their investments in the local asset favored by the signal realization, and reduce the position held in the other local asset. When the signal is sufficiently informative and short-sales are costly, local investors decide not to finance purchases of the perceived ``good'' local asset by selling short the perceived ``bad'' local asset. Instead they invest a lower fraction of their portfolio in foreign securities. This liberates resources that can be allocated in the local asset perceived to pay higher expected returns
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Bibliographic InfoPaper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 849.
Date of creation: 03 Dec 2006
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Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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International portfolio diversification; home bias; asymmetric information;
Find related papers by JEL classification:
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- F30 - International Economics - - International Finance - - - General
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
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