Home Bias in Open Economy Financial Macroeconomics

Abstract

Home bias is a perennial feature of international capital markets. We review various explanations of this puzzling phenomenon highlighting recent developments in macroeconomic modeling that incorporate international portfolio choices in standard two-country general equilibrium models. We refer to this new literature as Open Economy Financial Macroeconomics. We focus on three broad classes of explanations: (i) hedging motives in frictionless financial markets (real exchange rate and nontradable income risk), (ii) asset trade costs in international financial markets (such as transaction costs or differences in tax treatments between national and foreign assets), and (iii) informational frictions and behavioral biases. Recent theories call for new portfolio facts beyond equity home bias. We present new evidence on cross-border asset holdings across different types of assets: equities, bonds and bank lending and new micro data on institutional holdings of equity at the fund level. These data should inform macroeconomic modeling of the open economy and a growing literature of models of delegated investment. (JEL E13, F41, G11, G12, G15)

Financial deepening and economic growth

“…Recent resurgence of interest in analysing more complex nature of FD and economic growth in international scale, particularly after the financial crises of 2008, is seen in Scharfstein (2013), Farmer (2013), Coeurdacier and Rey (2012) and Olmo et al (2011).…”

Sovereign Credit Ratings and the Transnationalization of Finance – Evidence from a Gravity Model of Portfolio Investment

“…In the latter case, domestic asset holdings are exactly equal to the world market portfolio share of the respective country. As noted before, Coeurdacier and Rey (2013) consider informational asymmetries as frictions that explain the low degree of international portfolio diversification.…”

“…Investors persistently hold a far larger share of domestic assets in their portfolios than what is optimal in terms of the standard international capital asset pricing model (ICAPM). In their survey of the voluminous literature on home bias, Coeurdacier and Rey (2013) argue that informational asymmetries provide a particularly relevant explanation for the low degrees of international portfolio diversification observed in most countries. Domestic and foreign investors differ in their information sets on which they form expectations about risks and returns.…”

“…Rather than emphasizing the low levels of portfolio diversification, we set the focus on its increases in recent decades (also indicated by the figures in Coeurdacier and Rey 2013). Estimating a gravity equation derived from the Okawa/van Wincoop (2012) model, we use sovereign debt ratings as a proxy for CRA activities, and foreign portfolio investment (flows and stocks) as a proxy for capital mobility.…”

Italian Pension Funds Struggling with Domestic Sovereign Risk

“…In brief, there are mainly two types of explanations, namely market constrictions and investor behaviour. As for the first category, many factors may reduce returns from investing abroad or limit investors' capability to hold foreign assets transaction costs (Glassman and Riddick, 2001;Coeurdacier and Rey, 2013), differences in tax treatment, limits on cross-border investment (French and Poterba, 1991), real exchange rate (Fidora et al, 2006), and market transparency (Giofrè, 2013). But, as French and Poterba say, such constraints are not binding and appear unable to fully explain limited international diversification.…”