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Home bias and high turnover reconsidered

  • Francis E. Warnock
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    It is a stylized fact of international finance that foreign equities are underweighted (the home bias) but overtraded (the high turnover). Since stylized facts drive research, theoretical models are now developed to explain the puzzling coexistence of home bias and high turnover, first presented in Tesar and Werner (1995), and researchers now dismiss transaction costs as a plausible explanation of home bias. I show, however, that part of the puzzle--very high turnover rates on foreign equity portfolios--is based on inaccurate estimates of cross-border holdings. Revised estimates of holdings of foreign equities from comprehensive benchmark surveys produce foreign turnover rates that are much lower than previously reported and are comparable to domestic turnover rates. The implications of this finding are clear. First, researchers should no longer develop theoretical models to explain the coexistence of home bias and high turnover. Second, the relationship between transaction costs and home bias should be reexplored. On the second point, the basic intuition from Tesar and Werner (1995)--that transaction costs do not help explain the observed home bias--is confirmed using actual data on transaction costs in 41 markets.

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    File URL: http://www.federalreserve.gov/pubs/ifdp/2001/702/default.htm
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    File URL: http://www.federalreserve.gov/pubs/ifdp/2001/702/ifdp702.pdf
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    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 702.

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    Date of creation: 2001
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    Handle: RePEc:fip:fedgif:702
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    1. Ahearne, Alan G. & Griever, William L. & Warnock, Francis E., 2004. "Information costs and home bias: an analysis of US holdings of foreign equities," Journal of International Economics, Elsevier, vol. 62(2), pages 313-336, March.
    2. Philippe Martin & Helene Rey, 2000. "Financial integration and asset returns," LSE Research Online Documents on Economics 20201, London School of Economics and Political Science, LSE Library.
    3. Alaganar, V. T. & Bhar, Ramaprasad, 2001. "Diversification gains from American depositary receipts and foreign equities: evidence from Australian stocks," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 11(1), pages 97-113, March.
    4. Michael J. Brennan. and H. Henry Cao., 1997. "International Portfolio Investment Flows," Research Program in Finance Working Papers RPF-271, University of California at Berkeley.
    5. Karen K. Lewis, 1999. "Trying to Explain Home Bias in Equities and Consumption," Journal of Economic Literature, American Economic Association, vol. 37(2), pages 571-608, June.
    6. Massimo Guidolin, 2005. "Home bias and high turnover in an overlapping generations model with learning," Working Papers 2005-012, Federal Reserve Bank of St. Louis.
    7. Kang, Jun-Koo & Stulz, Rene M., 1997. "Why is there a home bias? An analysis of foreign portfolio equity ownership in Japan," Journal of Financial Economics, Elsevier, vol. 46(1), pages 3-28, October.
    8. 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.
    9. Rowland, Patrick F., 1999. "Transaction costs and international portfolio diversification," Journal of International Economics, Elsevier, vol. 49(1), pages 145-170, October.
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