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A rational explanation for home country bias

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  • Hasan, Iftekhar
  • Simaan, Yusif

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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  • Hasan, Iftekhar & Simaan, Yusif, 2000. "A rational explanation for home country bias," Journal of International Money and Finance, Elsevier, vol. 19(3), pages 331-361, June.
  • Handle: RePEc:eee:jimfin:v:19:y:2000:i:3:p:331-361
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    Cited by:

    1. Mishra, Anil V., 2016. "Foreign bias in Australian-domiciled mutual fund holdings," Pacific-Basin Finance Journal, Elsevier, vol. 39(C), pages 101-123.
    2. 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.
    3. Piti Disyatat & R. G Gelos, 2001. "The Asset Allocation of Emerging Market Mutual Funds," IMF Working Papers 01/111, International Monetary Fund.
    4. 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.
    5. Michael R. King & Dan Segal, 2004. "International Cross-Listing and the Bonding Hypothesis," Staff Working Papers 04-17, Bank of Canada.
    6. repec:dau:papers:123456789/9772 is not listed on IDEAS
    7. 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.
    8. Stewen, Iryna, 2014. "Is Real Exchange Rate Hedging Motive Still Important in Determining Equity Home Bias?," Annual Conference 2014 (Hamburg): Evidence-based Economic Policy 100571, Verein für Socialpolitik / German Economic Association.
    9. 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.
    10. Akito Matsumoto & Charles Engel, 2005. "Portfolio Choice in a Monetary Open-Economy DSGE Model," IMF Working Papers 05/165, International Monetary Fund.
    11. 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.
    12. 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.
    13. Liliane Karlinger, 2002. "The Impact of Common Currencies on Financial Markets: A Literature Review and Evidence from the Euro Area," Staff Working Papers 02-35, Bank of Canada.
    14. Mishra, Anil V., 2015. "Measures of equity home bias puzzle," Journal of Empirical Finance, Elsevier, vol. 34(C), pages 293-312.

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