When bonds matter: home bias in goods and assets

Recent models of international equity portfolios exhibit two potential weaknesses. First, the structure of equilibrium equity portfolios is determined by the correlation of equity returns with real exchange rates and non financial income; yet empirically domestic equities don't appear to be a good hedge against either risk factors; Second, equity portfolios are highly sensitive to preference parameters. This paper addresses both issues. It shows that in more general and realistic environments, (a) the hedging of real exchange rate risks occurs through international bond holdings, since relative bond returns are strongly correlated with real exchange rate fluctuations; (b) domestic equities can provide a good hedge against non-financial income risk, conditionally on bond returns. The model delivers equilibrium portfolios that are well-behaved as a function of the underlying preference parameters. Empirically, we find reasonable empirical support for the theory for G-7 countries. We are able to explain short positions in domestic currency bonds for all G-7 countries, as well as significant levels of home equity bias for the US, Japan and Canada.