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Can Parameter Uncertainty Help Solve the Home Bias Puzzle?

Author

Listed:
  • Bo Larsson

    (Department of Economics, Stockholm University, Sweden)

  • Dan Nyberg

    (Department of Economics, Stockholm University, Sweden)

Abstract

A well-known puzzle in international finance is the equity home bias. This paper illustrates a mechanism where exchange rate estimation risk causes equity home bias. Estimation risk is introduced into a standard mean-variance portfolio framework by having return time series with different lengths. We argue that the exchange rate return history, which is a part of the local currency return on a foreign investment, is likely to be substantially shorter than the available return histories of equity indices due to, for example, exchange rate regime shifts. To econometrically deal with return histories of different lengths we utilize a framework devised by Stambaugh (1997). The impact of estimation risk on an optimal portfolio is tested with data from Sweden and the U.S. Our results suggest that explicitly accounting for estimation risk causes the domestic investor to increase his fraction of domestic assets. While the introduction of exchange rate estimation risk is not powerful enough to explain the whole home bias observed in data, the results of this paper illustrate a mechanism that is often overlooked in discussions of international portfolio diversification.

Suggested Citation

  • Bo Larsson & Dan Nyberg, 2003. "Can Parameter Uncertainty Help Solve the Home Bias Puzzle?," Ekonomia, Cyprus Economic Society and University of Cyprus, vol. 6(2), pages 187-209, Winter.
  • Handle: RePEc:ekn:ekonom:v:6:y:2003:i:2:p:187-209
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    More about this item

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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