Model uncertainty, financial market integration and the home bias puzzle

Abstract

This paper investigates to what extent ongoing integration has eroded the equity home bias. To measure home bias, we compare observed foreign asset holdings of a set of 25 developed markets with optimal weights obtained from 5 benchmark models. Under the assumptions of the classical model in home bias studies, the International CAPM (I-CAPM), optimal portfolio weights are given by the relative world market capitalization shares. Four alternative models that allow for various degrees of mistrust in the I-CAPM and involve returns data in computing optimal portfolio weights, generally indicate a substantially lower yet still positive home bias. We observe a reduction in the home bias for many countries at the end of the 1990s and link the sharp decrease in the equity home bias to time-varying globalization and regional integration.JEL classification: F36, G11, G15

International asset allocation for incompletely-informed investors

“…(11). Our results are consistent with the decline in the home bias observed by both Ahearne, Griever, and Warnock (2004) and Baele, Pungulescu, and Ter Horst (2007), with the estimation errors of the partially-informed agents ultimately disappearing as the time horizon approaches infinity. This suggests that, over time, the partially-informed agents' portfolio strategies will converge to those of the fully-informed agents, with the home bias relative to foreign investment ultimately disappearing.…”

“…Investors can improve the quality of their information by updating their beliefs based upon more realized returns over time; over a sufficient period of time, their estimation errors will ultimately disappear, and they can then adjust their portfolio choices to hold more foreign assets. This thereby suggests that there is a general reduction in the level of home bias over time, as found in both Ahearne, Griever, and Warnock (2004) and Baele, Pungulescu, and Ter Horst (2007).…”

“…The detailed identification of the process paths of the estimation errors and unobservable expected returns provided by Feldman (2007) leads to complete information. Although home bias has been slightly reduced (Ahearne, Griever, and Warnock, 2004;Baele, Pungulescu, and Ter Horst, 2007), analogous to the portfolio problem examined in Brennan (1998) and the outsider problem dealt with in Lundtofte (2006), the majority of the market participants, who are smaller investors, use only publicly available information to make their portfolio choices. We assume that, over time, investors can learn of the true value of expected Finally, following Alder and Dumas (1983) and Dothan and Feldman (1986), we assume that the two types of agents maximize a time-additive, von Neumann-Morgenstern expected utility of lifetime consumption.…”

“…Within our model, prior expectations of the returns of the home and foreign assets are linked by the correlation between them. As noted in both De Santis and Gerard (2009) and Baele, Pungulescu, and Ter Horst (2007), the evident decline in the magnitude of home bias in Europe implies that the establishment of the European Monetary Union (EMU) enhanced the transmission of regional information, thereby reducing the overall level of home bias.…”

“…However, the precise estimation of expected returns is far more difficult than estimating the variance in returns 2 ; thus, estimation errors are increasingly likely when investors have to consider the expected returns of both home and foreign assets. This tendency thereby creates a problem for the current explanations of the home equity bias (Baele, Pungulescu, and Ter Horst, 2007), as well as concerns as to whether the econometric assumptions of an estimation procedure are consistent with the assumptions and structure of the original portfolio model (Feldman, 2007).…”