2013-Home Bias in Open Economy Financial Macroeconomics

Home Bias in Open Economy Financial Macroeconomics
Author(s): Nicolas Coeurdacier and Hélène Rey

Source: Journal of Economic Literature , MARCH 2013, Vol. 51, No. 1 (MARCH 2013), pp.
63-115
Published by: American Economic Association
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Journal of Economie Literature 2012, 51(1), 63-115
http://dx. doi.org/10.1257fjel.51.1.63
Home Bias in Open Economy

Financial Macroeconomics
Nicolas Coeurdacier and Hélène Rey*
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 (Hi) 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, Gil, G12, G15)
1. Introduction fully mobile across borders. Because foreign

equities provide great diversification oppor
Home bias is a perennial feature of inter- tunities, a point made early on in Grubel
national capital markets. Nineteenth century (1968), Levy and Sarnat (1970) and Solnik
economists called it the "disinclination of (1974), falling barriers to international trade
capital to migrate."1 Standard finance theory in financial assets over the last thirty-years
predicts that investors hold a diversified port- should have led investors across the world to
folio of equities across the world if capital is rebalance their portfolio away from national
assets toward foreign assets. The process of
"financial globalization" fostered by capital
'Coeurdacier: SciencesPo and CEPR. Rey: London aCCOunt liberalizations electronic trading,
Business School, CEPR and NBER. Ebrahim Rahbari, increasing exchanges of information across
Nelson Costa-Neto and Francesca Monti provided excel- borders, and falling transaction COStS has Cer
lent research assistance. Coeurdacier thanks the Chaire . . i i j , i . . i i
d'Excellence de l'Agence Nationale pour la Recherche tainly led t0 a lar§e ^cre
for financial support. Rey gratefully acknowledges the asset trade (Lane and
European Research Council grant number 210584 on However, investors seem
"Countries'external balance sheets, dynamics of interna- ,1 r 11 r o. r • . ,• i j.
tional adjustment and capital flows" for financial support. reaP the fuI1 berle,fitS °f interna
1 Reported in Flandreau (2006). sification and hold a disproportiona
63

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64 Journal of Economie Literature, Vol. LI (March 2013)
of local equities, a phenomenon referred first focused on models with equities only,
to as the "home bias in equities." Since the But the importance of considering portfo
seminal paper of French and Poterba (1991), lio choices across a broader class of assets
the home bias in equities has continuously (bonds, corporate debt, equity . . . ) is now
intrigued and fascinated financial economists widely recognized. We develop a standard
and international macroeconomists. Despite two country/two good Dynamic Stochastic
better financial integration, the home bias General Equilibrium (DSGE) model with
has not decreased sizably: in 2007, U.S. endogenous portfolio choice and allow for
investors still hold more than 80 percent of equity trade in first instance, as in the early
domestic equities, a much higher proportion literature, and then generalize the set up to
than the share of U.S. equities in the world accommodate trade in bonds and equity.
market portfolio. Indeed, home bias in equi- This allows us both to present recent meth
ties is still observed in most countries and odological developments to fully characterize
tends to be higher in emerging markets. portfolios in this class of models and to show
Many explanations have been put forward the limitations of the early literature. These
in the literature to explain this very robust new models also call for new portfolio facts,
portfolio fact. We do not intend to provide a Accordingly, we present some new evidence
definite answer nor choose among alternative on international holdings across different
explanations, as they probably all contribute types of assets: equities, bonds, and banking
to part of the gap. Our goal is to review where assets. We focus on portfolio investment and
theory has led us, provide relevant empiri- abstract from Foreign Direct Investment, as
cal facts and take a stand at what might be its determinants may be of a different nature
the next challenges ahead. We distinguish and are studied extensively in the trade lit
between three broad classes of explanations: erature. Finally, we present some new micro
(i) hedging motives in frictionless financial data on institutional holdings of equity at the
markets (real exchange rate and non-tradable fund level. These data should inform mac
income risk), (ii) asset trade costs in interna- roeconomic modeling of the open economy
tional financial markets (such as transaction as well as models of delegated investment,
costs, differences in tax treatments between which belong to a fast-growing literature:
national and foreign assets or differences in a large share of international investment is
legal frameworks), and (iii) informational fric- intermediated.
tions and behavioral biases. We will review In section 2, we present the standard defi
these explanations, highlighting important nition of home equity bias and some recent
recent developments in macroeconomic measures across countries and across time,
modeling of the open economy, referred to as In section 3, we focus on the recent meth
Open Economy Financial Macroeconomics. odological developments in the macroeco
We will also discuss asymmetric information nomics literature. In section 4, we focus on
models, including the recent literature with the role of hedging motives as a source of
endogenous information acquisition. equity home bias. We use standard dynamic
We put some emphasis on recent devel- models of the Open Economy Financial
opments in the macroeconomics literature, Macroeconomics literature. In section 5,
which has embedded nontrivial portfolio we present the literature on trade costs in
choices in standard two country general financial markets (transaction costs, interna
equilibrium macro models. Explaining tional taxation, legal frameworks). In section
equity home bias has been one of the main 6, we review the finance literature on infor
motivations for this literature, which has mation asymmetries and behavioral biases.

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Coeurdacier and Rey: Home Bias in Open Economy Financial Macroeconomics 65
In section 7, in line with recent theoretical domestic equity and the share of domestic
work, we present some new evidence on equity in the world market portfolio:3
aggregate portfolio holdings across a wider
range of assets. We also present new port (1) EHBj = 1 -
folio facts at the fund level and discuss leads
for future research. Section 8 concludes. Share of Foreign Equities in Country i Equity Holdings
Share of Foreign Equities in the World Market Portfolio
2. The Equity Home Bias:

When the home bias measure for country
Definition and Measure
i EHB¡ is equal to one, there is full equity
home bias; when it is equal to zero, the port
2.1 Definition
folio is optimally diversified according to the
French and Poterba (1991) were the basic International CAPM.
first to our knowledge to document domes 2.2 Evidence across Time and across
tic ownership shares across countries. Using Countries
data for the United States, Japan, the United
Kingdom, France, and Germany, they show While one could argue that, at the end
that investors hold a disproportionate share of the 1980s, international capital markets
of domestic assets in their equity portfolios. were far from being frictionless and this
In 1989, 92 percent of the U.S. stock market could contribute to rationalize home bias,
was held by U.S. residents. Analogous num this line of explanation seems more doubt
bers for Japan, the United Kingdom, France, ful today. Despite increased financial inte
and Germany are respectively 96 percent, 92 gration, the equity home bias remains a
percent, 89 percent, and 79 percent. They pervasive phenomenon across countries and
label this lack of cross border diversification across time (classic surveys include Lewis
the equity home bias.2 This is a well-known 1999 and Karolyi and Stulz 2003). See also
puzzle in international finance: in a world Sercu and Vanpée (2008) for recent evi
with frictionless financial markets, the most dence). In figure 1, we show the evolution of
basic International Capital Asset Pricing home bias measures in developed countries
Model (CAPM) model with homogenous across regions of the world: it has decreased
investors across the world would predict that over the last twenty years with the process of
the representative investor of a given country "financial globalization" but remains high in
should hold the world market portfolio. In most countries (see also table 1 for a recent
other words, the share of his financial wealth snapshot of home bias measures for selected
invested in local equities should be equal to
the share of local equities in the world mar
ket portfolio, a prediction that contradicts the 3 See, for instance, Ahearne, Griever, and Warnock
most casual observation of the data on portfo (2004). Another commonly used measure in finance is a
deviation from a benchmark mean-variance portfolio.
lio holdings. As a result, the measure of equity Benchmark portfolio weights are calculated from a mean
home bias (EHB) that is most commonly used variance optimization problem with sample estimates of
the means and variance-covariance matrix of returns. The
is the difference between actual holdings of
main issue in the existing literature adopting the finance
approach are how to measure returns and covariance
matrices. Papers differ in the extent to which they use real
2Bohn and Tesar (1996) estimate the share of foreign or nominal returns, how they estimate expected returns,
equities in the U.S. portfolio to be still very low in 1995,and how they deal with structural breaks and nonstationar
equal to 8 percent. Ahearne, Griever, and Warnock (2004)ity. As a result, there is a degree of heterogeneity in the
estimate it to be slightly above 10 percent in 2000. estimates of expected returns and second moments.

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ooo5©^<McoTt|mcof-ooa>o^c<i
ocoo©©©©©©©©©©©©©
050505050505©©©©05©©©©
'—I '—I '—I >—I ^-1 r—,^-Hi—l^-l,—I,—I,—ICMCMCN1
Figure 1. Home Bias in Equities Mea
Note: The country measure EHB, is market
Sources: Authors' calculations. International

Countries: Australia and Japan; Europe (A
Netherlands, Spain, Sweden, Switzerland, U
countries). On average,
diversified the degree equity of p
countries
bias across the world is 0.63 (lower and do in
where monetary union after
downward trend 1999in
degree For
to have had an effect).4 of home the deve bi
world, this means 0.9 that (smallerthe share in emer of f
Latin
equities in investors' America)is
portfolios and
rou
third of what it should
tries hold be ifone-tenththe bencho
is the basic International
equities CAPM. they should In fi
the basic International
we construct a similar CAPM model.
indicator for
ing markets. Emerging
This robust stylized markets
fact has received con ha
siderable attention from both the finance
literature and the macroeconomics litera
4 See Coeurdacier and Martin (2009) and Fi
Fratzscher, and Thimann The
ture. main difference
(2007) for between
studiesthese on th
of the Monetary Uniontwo sets
on of cross-border
literature relies on some model
equity d
cation. Kalemli-Ozcan, Papaioannou, and Peydr
show that the euro's ing assumptions.
impact on To financial
simplify, the traditional
integra
primarily driven by finance literature has
eliminating the triedcurrency
to rationalize the risk.

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TABLE 1
Home Bias in Equities in 2008 for Selected Countries
Domestic market in % Share of portfolio in Degree of equity home bias

of world market capitalization domestic equity in % = EHB,
Source country (1) (2) (3)
Australia 1.8 76.1 0.76
Brazil 1.6 98.6 0.99
China 7.8 99.2 0.99
Canada 2.7 80.2 0.80
Euro Area 13.5 56.7 0.50
Japan 8.9 73.5 0.71

South Africa 1.4 87.8 0.88
South Korea 1.4 88.5 0.88
Sweden 0.7 43.6 0.43
Switzerland 2.3 50.9 0.50
United Kingdom 5.1 54.5 0.52

United States 32.6 77.2 0.66
Note: For Euro Area countries, within Euro Area cross-border equity holdings are considered as Foreign Equity
Holdings.
Sources: Authors' calculations. International Financial Statistics, Consumer Portfolio Investment Survey and World
Federation of Exchange.
equity home bias in multicountry models of financial economists and macroeconomists

portfolio choice where asset prices and their are intrigued by this fact.6
second moments are given (in particular in
these models the risk-free interest rate is
3. Open Economy Financial
exogenously given). The macro literature Macroeconomics
has tried to integrate international portfo
lio decisions in otherwise standard DSGE The theoretical macroeconomic literature
points toward potential gains from inter
models of the international economy. These
models have a fully general equilibrium national diversification to hedge national
production risk. In the presence of imper
structure and asset prices and their second
moments are endogenously determined.5 fectly correlated productivity shocks or out
put shocks across countries, owning foreign
The motivation is however the same: foreign
equities seem to offer diversification benefits
that are not reaped by investors and both6 The finance literature tends to focus on the diversifica
tion gains looking at asset price data and to evaluate how
an increase in the share of foreign equities would improve
the portfolio performance based on some criteria. The
5The dichotomy, which historically seems relevant, macro-finance literature tends to use consumption data
appears increasingly artificial as more papers bridge the to measure the potential welfare gains from international
two strands of literature. risk-sharing. See section 6 for a discussion.

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2001 2002 2003 2004 2005 2006 2007 2008
Figure 2. Home Bias in Equities M
Note: The country measure EHB¡ is marke
Sources: Authors' calculations. Internation

Countries: Central and South America (Ar
South Africa; Central and Eastern Europe
Poland, Romania, Ukraine); Emerging A
Singapore, Thailand, Armenia, Kazakhstan
equity could help to smooth cons

This is most obvious in the conte
two country model with one sin
able good, as, e.g., in Lucas (1982):
a world, domestic and foreign inve
an identical portfolio of claims
(equities), the market portfolio,
sifying optimally national output
the textbook finance portfolio theo
a world the home bias in equities i
failure of the standard diversificat
However, one should be cautious:
tors across the world would hold
portfolio, only if they were homo
reality, heterogeneity across inves

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how recent methodological developments in dynamics of the model only depends on

Open Economy Financial Macroeconomics the steady-state portfolio. In addition to
allow us to solve for (nontrivial) portfolio these conceptual insights, Devereux and
decisions in D S GE models. Sutherland (2011) also provide a formula
„ , . 7, . , „ ,,, , that can be used to compute portfolios
3.1 MethodotoPical Breakthrough , ,. „ . r . , ', , r r ,
& ° analytically in a tairly general class oi mod
Until recently, most macroeconomic models. In a companion pa
els of the international economy relied mostly Sutherland (2010), the a
on the following asset structures: either one order to solve for the fir
noncontingent bond traded internationally the portfolio, a second-or
or complete asset markets through Arrow- of the nonportfolio equat
Debreu securities. None of these models is needed, while the
could say anything about gross foreign asset need to be approximated
holdings and the extent to which tradable Portfolio changes (arou
assets could be used to share risks interna- portfolios) are driven by
tionally. Recent methodological advances moments (third-order t
have allowed a much richer structure of asset mine changes in expect
trade to be examined. assets. It is then also true that the second
Building on perturbation methods (see order dynamics of th
Judd 1998), Devereux and Sutherland the first-order dynamic
(2011) develop a solution method that authors show that ap
allows standard linear solution techniques can be computed analy
for macroeconomic models to be adapted In simultaneous w
to solve for models with portfolio choice. Wincoop (2010) dev
Standard linear solution techniques can- nique that is analogous
not directly be applied since these methods in Devereux and S
rely on a first-order approximation around main difference is that
a deterministic steady state: to a first order (2010) rely on numeri
approximation, assets are perfect substi- for portfolios. This r
tutes, as they deliver the same expected tional effort, but also
return, so portfolio choice is not pinned tion method can be ap
down. Devereux and Sutherland's work of models. To compute
relies on several insights. Firstly, building lios, they linearize nonp
on earlier work by Judd and Guu (2001) and to the first-order for a
Samuelson (1970), they show that the steady then solve for the end
state portfolio can be derived as the portfo- a fixed-point in a seco
lio in a noisy environment and letting the tion of the portfolio
noise go to zero. Secondly, they show that in Devereux and Su
in order for the steady state portfolio to be show how going one o
well defined, a second-order approximation approximation allows t
of the portfolio equations (Euler equations) dynamics. They apply t
needs to be considered, while only the first- country/two good m
order dynamics of the other equations of the each country and show
model are required to pin down steady state ics relates to the time
portfolios (also called zero order portfolio). returns and second
Finally, the authors show that the first-order lar, they investigat

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outflows and inflows, relate them to portfolio approximations, they may also be inaccurate
growth and portfolio reallocation,7 and assess in models that exhibit strong nonlinearities,
the performance of the model looking at bal such as models with borrowing constraints.
ance of payments statistics on capital flows. Lastly, the approximation of the decision
Other recent work that tackles the challenge rules in these methods is made around the
of solving for portfolio choice are Evans deterministic steady state. However, the
and Hnatkovska (2006 and 2008) and Judd, deterministic steady state might not be the
Kubler, and Schmedders (2002). The meth stationary steady state of the model in pres
ods developed in Evans and Hnatkovska ence of risk. Coeurdacier, Rey, and Winant
(2008) and Judd, Kubler, and Schmedders (2011) use perturbation methods around
(2002) can be applied to very general classes the "risky steady state," defined as the point
of models, but are quite complex and present where agents choose to stay at a given date if
significant departures from standard DSGE the realization of shocks is 0 at this date but
solution methods. if they expect future risk.8 The welfare impli
cations for risk-sharing can be quite differ
3.2 Shortcomings and Extensions
ent from the standard ones around the risky
The main advantage of the perturba steady state since uncertainty directly affects
tion methods developed by Devereux steady-state variables. While still local, such
and Sutherland (2011) and Tille and van a method should be more accurate when
Wincoop (2010) are: (1) they are very easy decision rules in presence of risk are signifi
to implement as they are close to standard cantly different from the ones obtained when
approximation methods used in DSGE mod risk goes toward zero (as in Devereux and
els; (2) they can be applied to a broad range Sutherland 2011). The question of accuracy
of environments (complete and incomplete of these solution methods is not easily tack
markets models, a potentially large number led however as for most models for which
of shocks and/or securities); and (3) they pro they are implemented, one cannot provide
vide (approximate) closed-form expressions exact numerical methods. Exceptions of
for portfolios in many cases. These methods two-country/two goods models where solu
face however some limitations as they rely tions can be found without approximations
on local approximations around the deter are models with log-linear preferences as in
ministic steady state: as any local methods, Pavlova and Rigobon (2007, 2009, 2010).9
they are valid around the point of approxi Ultimately, one should expect the devel
mation, which is problematic when there are opment of global methods to emerge in
large deviations away from this point. This order to solve portfolio choice models with
can arise for instance in presence of large multiple agents, multiple goods and mul
shocks (such as disaster risks, see, e.g., in tiple securities. Developing global methods
Barro 2006) or when the problem is nonsta would be useful as they would potentially be
tionary. For example, in incomplete markets
models, the distribution of wealth across
countries may have a unit-root and there 8 For early work on the risky steady state, see Julliard
fore the solution may wander away from and Kamenik (2005), For another application of the risky
steady state concept in a different context, see Gertler,
the approximation point. Since the methods Kiyotaki, and Queralto (forthcoming).
are mainly based on first- and second-order 9 See also Devereux and Saito (2006). As Pavlova and
Rigobon (2007, 2009, 2010), Devereux and Saito (2006)
use a continuous time framework that allows some analyti
7 See also Kraay and Ventura (2000, 2003) for a similar
cal solutions to be derived, but it can only be applied to a
terminology. restricted class of models.

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adequate in environments where standard • Nontradable income risk: investors

perturbation methods fail and they could also receive a part of their income (wages
provide insights on the accuracy of perturba in particular) that cannot be traded in
tion methods. Recent work in that direction financial markets.10
includes Dumas and Lyasoff (2011) in finite
horizons models and Chien, Cole, and Lustig In other words, because investors in dif
(2011) in a one-good closed economy model ferent countries have different exposure to
with multiple agents. Extending these meth real exchange rate risk and/or to nontradable
ods to standard international macro models income risk, they will hold different equity
is a next important step. portfolios in equilibrium. It is important to
Despite their limitations, perturbation understand that in these cases, equity port
methods constitute a major improvement folio "biases" are neither inefficient nor the
that makes it possible to incorporate non consequence of some frictions in financial
trivial portfolio choice in models of the markets. The hedging of domestic sources
open macroeconomy. These methodologi of risks leads to different optimal portfolios
cal improvements have given a new life to across borders but perfect (or almost per
the literature investigating the origins of fect) risk-sharing is preserved.
portfolio biases. A first generation of mod In order to analyze how these hedging
els of Open Financial Macroeconomics has motives affect equity portfolios, we present
looked at the hedging of real exchange rate a benchmark two-country/two-good model
risk and nontradable income risk as a source where the only traded assets are equities
of portfolio biases in models with equities of both countries. We show how log-linear
only. A second generation of models has ization techniques can be used to derive
emphasized the importance of describing (zero-order) steady-state portfolios. We also
portfolios with a richer menu of assets and revisit some of the results of the literature
has developed models with multiple asset regarding the hedging of real exchange rate
classes (bonds and equities). We review risk and nontradable income risk in an equity
these two strands of literature sequentially only model. In particular, we show the dif
in the next section. ficulties to rationalize the equity home bias
in such a framework. In section 4.2, we will
show how a multiple asset class model pro
4. Hedging Motives in Open Economy vides an answer to most of these difficulties.
Financial Macroeconomics
4.1 Hedging Motives in a Benchmark Model
Hedging motives lead to departure from
with Equities Only
the benchmark model of Lucas (1982)
where homogeneous investors across the
4.1.1 Set-up and First-Order Conditions
world hold identical portfolios. By hedging,
we mean choosing financial claims that help There are two symmetric countries, Home
insulate investors from sources of risk affect (H) and Foreign (F), each with a representa
ing their income streams. The sources of risk tive household. Country i — H,F produces
developed in the literature are the following: one good using labor and capital. We assume
that capital is fixed for now and will allow for
• Real exchange rate risk: the prices of
investors' consumption goods fluctuate
10The presence of government spending shocks can
and this affects the purchasing power of also generate a source of nontradable income risk due to
their income. tax changes.

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endogenous capital accumulation in the sub Technologies and Firms' Decisions

sequent section 4.2. All markets are perfectly
competitive. In period t, country produces yit units of
good i according to the production function
Preferences
(5) yu = eu(k0)a(lu)i-<*,
Countiy i is inhabited by a representative with 0 < a < 1. k¡¡ is the country's initial
household that has the following lifetime stock of capital. It is fixed. Total factor pro
utility function: ductivity (TFP) 6i t >0 is an exogenous ran
dom variable.
v2^ / C1-"
f-il-tr 11+ui
i,t i,t There is a (representative) firm in country
(2)
(=0 \ i — o 1 + LO , i that hires local labor and produces output,
using technology (5). Due to the Cobb
where u> is the Frish-elasticity of labor sup Douglas technology, a share 1 — a of output
ply {uj > 0) and a the relative risk aversion at market prices is paid to workers. Thus, the
parameter (a > 0). Ci t is is aggregate con country i wage incomes are:
sumption in period t and lu is labor effort.
Ci t is a composite good given by: (6) wi tli t = (1 - ot)pi t yi t,
(3) Ci t = [oV+iclJ*-1** where wit is the country i wage rate.

A share a of country i output at market
+ (1 - prices is paid as a dividend di t to shareholders:
with j f i, (7) di t — ap¡ t yi t.
where cj t is country is consumption of the Financial Markets and Instantaneous

good produced by country j at date t. <fi > 0
Budget Constraint
is the elasticity of substitution between the
two goods. In the (symmetric) determinis Financial markets are frictionless. There is
tic steady state, a is the share of consump international trade in stocks. The country i
tion spending devoted to the local good. representative firm issues a stock that repre
We assume a preference bias for local sents a claim to its stream of dividends [di t}.
goods11,1 < a < 1. The supply of shares is normalized at unity.
The welfare based consumer price index Each household fully owns the local stock, at
that corresponds to these preferences is: birth, and has zero initial foreign assets. Let
SjJ+i denote the number of shares of stock j
(4) Pi,t=[a(piJ)1^+ (1 held by country i at the end of period t. At
date t, the country i household faces the fol
lowing budget constraint:
where pit is the price of good i. (8) PUCU +pltS'it+1 +p?,tSjtt+l
= wi,tkt + (du + pit)S[t

This "consumption home bias" is assumed exog
enously. It has been extensively studied in the trade litera
ture since the classic paper of McCallum (1995). ~f t + pj,t)Sj t, j ^ i,

210.12.45.98 on Tue, 05 Apr 2022 02:31:57 UTC
where p?( is the price of stock i. state. In this section, we provide closed
form solutions for "zero-order portfolios"
TT 7 7 j T-. • • j (denoted by variables without time sub
it owsenoiaDecisions and . ,r , . . ,
. ,, j, , scripts) S;, S., i.e., portfolio decision rules
Market Clearing Conditions ! . , , -, . . , r , .
& evaluated at steady-state values ot state van
Each household selects portfolios, con- ables. These portfolios can be
sumptions and labor supplies that maximize by linearizing the model aro
her lifetime utility (2) subject to her budget ministic steady state. We show t
constraint (8) for t > 0. The following equa- structure (two assets with t
tions are first-order conditions of that deci- shocks) is locally complete in t
sion problem: up to a first-order linear approximation, the
consumption allocation is efficient (in other
(9) c- — a( P'J \ words there is perfect risk sharing up
\Pi,t) ' first-order approximation of the model).
_ The method we use to solve for portfolios
c\ f = (1 —
"j,t - V-L - U'\p~a)l — I „ is then slightly different from Devereux an
Sutherland (2011) as it does not require a sec
ond-order expansion of the Euler equations
Kt = i,t( j ) Ci.t~a (equation 10). We simply derive the portfoli
that replicates the efficient allocation up to
,S a first-order approximation of the nonport
Pi, t Pj,t+i + dj,t+i
(10) 1 — Et0\ folio equations. This method is simpler but
Ci t ) Pi,t+i pit less general than Devereux and Sutherland
(2011) as theirs can also be applied in models
for j = H, F. with incomplete financial markets.
Equation (9) represents the optimal alloca- r ,. . ,. r,

. 1 r r. 1 , Lop-Linearization of the Model
tion ot consumption spending across goods, °
and the labor supply decision. Equation (10) In what follows, zt = denotes t
shows the Euler equations with respect to ratio of Home over Foreign variab
the two stocks. zt = (zt — z)/z denotes the relative deviation
Market-clearing in goods and asset mar- of a variable zt from its steady-stat
kets requires: The Home country's CPI-based real
p
p exchange is RERt = -pA Linearizing this
(11) C¡ft + CHt = yHt, cFt + cFt = llFt> . . / . ,iw
' expression gives (using (4)):
(12) Sjj +sf,:l = SÇj + Sj, = 1. (13) _ = = )

4.1.2 Zero-Order Equilibrium Portfolios
where qt = Phj/Pfj denotes the country H
Equilibrium portfolio holdings chosen at terms of trade. Due to consump
date t (S lt+1, Sj[ t+i) are functions of state bias (a > |), an improvement of Hom
variables at date t. Devereux and Sutherland of trade generates an apprecia
(2011) show how to compute Taylor expan- Home real exchange rate (without h
sion of the portfolio decision rules, in the in consumption, the real excha
neighborhood of the deterministic steady constant).

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In an equilibrium with locally complete Up to the first order, country i's efficient
markets, the ratio of Home and Foreign consumption spending at date t equals date
marginal utilities of aggregate consumption t wage income, witlit, plus the financial
is proportional to the consumption-based income generated by the equity portfolio S.13
real exchange rate (Backus and Smith 1993; Subtracting the "static" budget constraint
Kollmann 1995). Linearization of this risk of country F from that of country H and
sharing condition gives: using the risk-sharing condition (14) yields
the following log-linearized "static" budget
(14) —cr(CH t — CF t) = (2a — l)qr constraint:
Using intratemporal first-order condition (17) (PHjCHj-PFjCFj)

for consumption (9) and market-clearing
condition (11), one can show that when (14) = (l-I) (2a-l)qt
holds, relative world consumption demand is
1RÊR,
given by yt = yHj/yFj = (c",t + cfHj)/{cfFj +
cF t) and satisfies in log-linearized terms:12
= (1 — a)wtl, + (2 S — 1) adt,
(15) yt = where wtlt = wHtlHt — wFtlFt denotes

relative labor income and dt = d,U t — dF t
-[^(1 -{2a- l)2) + (2a - 1 )2^]q( denotes the relative dividend.
= -A qt,
This expression shows the changes in
country H income (relative to the income of
F) necessary to finance the changes in con
where À s cp(l — (2a — l)2) + â > 0. sumption consistent with efficient risk-shar
Thus Home terms of trade worsen when the ing (up to first order).
relative supply of Home goods increases as
Foreign goods are scarcer. Partial Equilibrium Zero-Order Portfolios
Ex ante symmetry implies that the zero
order portfolios have to satisfy these con The "static" budget constraint is useful to
ditions: S = Sg = Si = 1 — Sfh = 1 - S£; S derive the equilibrium portfolio as a function
describes the (zero-order) equilibrium equity of variance/çpvariance ratios. Taking the cova
portfolio. Note that S denotes a country's riance with dt in (18) gives the following port
holdings of local stock. folio (we implicitly assume that the equity
We will show that there exists a unique portfolio supports efficient risk-sharing up to
a first-order, which is verified below):
portfolio S, which, for consumptions con
sistent with the linearized risk-sharing con
dition (14), satisfies the following "static" (18) s =
budget constraint: 2 2 a var(rij)
(16) PuCi t = wi t li t + Sdi t + (1 - S)djj, + I (1 - 7f) cov(RER,dt]
" ' var (dt)
for i = H,F.
13 Kollrnanii (2006b) and Coeurdacier, Kollma
Martin (2010) shows that if this "static" budget
12See Coeurdacier (2009) and Coeurdacier,
holds,Kollmann,
then the present value budget constraint o
Martin (2008) for similar expressions. i is likewise satisfied, up to a first order.

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This expression holds in many classes of power. On the other hand, since local goods
models (with equity only) as we only need are more expensive, households could
the budget constraints and generic first- be better off consuming when goods are
order conditions to derive it. It is the depar- cheaper. The dominating effect depends on
ture of many empirical studies. The same how much households want to smooth their
expression also holds in terms of returns consumption across states. For consumers
instead of income flows. sufficiently risk-averse (cr > 1), the former
The portfolio departs from the fully diversi- effect dominates and households want to
lied one with weights 1/2 in both equities (as increase their income when their consump
in Lucas 1982) in presence of labor income tion goods are more expensive. Thus, they
risk and/or real exchange rate risk. It indicates build their portfolio by choosing assets with a
that investors would favor local equity if: high pay-off when local goods are expensive.
For the log-investor (cr = 1), the two effects
(i) Relative dividends covary negatively cancel out and the hedging term disappears.
with (relative) labor income (term c"v'ui'i'<^,>).
var (dt)
This term is referred as the hedging of non- General Equilibrium Zero-Order Portfolios
tradable income risk. Note that equation (18) is a partial equi
As labor income accounts for more than librium exPrf ^n. In general equilibrium
two-thirds of total income, this term might macro models' [he above variance/covari
lead to potentially large portfolio biases, the term,s fn be expressed as a function
covariance term being multiplied by of the underlying parameters of the model.
Households cannot trade financial claims Since labor income and dividends are a con
on their labor incomes and will use existing stant share of °ût ((6) and (7))' r«,ative
financial assets to hedge this nontradable labor income (wf)jind dividends (dt) are
income risk. Intuitively, households want to equal and given by: wtlt = dt = q~t + yt.
insure themselves against a fall in their labor Substituting into (17) and using (15) gives:
incomes and in the returns to their human
wealth by holding financial assets that pay (19) (1 — -¡j j ( 2a — 1 )q~t
more in these bad states. If local equities
have higher returns (than abroad) when = {(1 — a) + a(2S — l)}(q) + yt)
local returns to nontradable wealth are lower
(than abroad), households will bias their = {(1 — a) + a(2S — 1)}(1 - A)<^.
portfolio toward local equities.
The asset structure supports full risk-sharing,
(ii) Relative dividends covary posi- up to first-order, if (19) holds for all realiza
tively with tlie real exchange rate if cr > 1 tions of the (relative) exogenous productivity
(term cov(R£"'d')). This term is referred as shocks $t) (or equivalently all realizations of
vaiW the terms-of-trade qt). The following port
the hedging of real exchange rate risk. folio s ensures that (19) holds fo
realizations of qt:
The optimal hedging of real exchange rate
risk depends on two forces going in oppo- ,-n) o _ 1 1 (1 — Q)
site directions: when local goods are more 2 2a
expensive, consumers need to generate more ^ j (2a — 1)
income in order to stabilize their purchasingcr' ~a (A
2^—1 )'

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The equilibrium portfolio is the sum of (a) A > 1 (i.e., an elasticity of substi
three terms: tution f roughly above unity): the
hedging of real exchange rate ri
(i) The first term A is a pure diversifica- generates a For
tion term. It would prevail if there The reason is the
were no hedging motives as in Lucas ative) fall in loca
(1982). In the absence of heteroge- by a bad product
neity across investors, there is full gers a moderate
diversification of national output risk. Home terms-o
We derive the Lucas portfolio when ate appreciation
a —> 1 (no human capital risk) and real exchange rate
when a = 1/2 (no real exchange rate decrease in Home
risk). Foreign equities are more valu
able since they have high
(ii) The second term -is the five) returns despite the Home
hedging of nontradable income risk rea' exc'lange rate appreciation,
(as in Baxter and Jermann (1997)):
changes in output driven by produc- ^ ^ ^ < ^ elasticity of substi
tivity shocks are shared in constant t*on f*' roughly below unity):
proportion (Cobb-Douglas produc- (relative) fall in local output t
tion). This leads to a perfect corre- gers a stronger improvement
lation between labor incomes and Home terms-of-trade and
capital incomes: households should a stronger appreciation of th
short the local stock to hedge human Home real exchange rate. As t
capital risk. Note that in the present relative price response is str
model, the portfolio is exactly the ger> Home e9uity excess retu
one of Baxter and Jermann (1997) increase. Home investors exhi
in the absence of real exchange rate Home equity bias as Home equit
risk (a = 1/2) have higher returns when the
Home real exchange rate appre
(iii) The third term - 1(1 - I) (2g-I} is ciates' This is the cas
2 a a(A-i) sized by Kollmann (2006b).
the hedging of real exchange rate
risk. This term is the same as the one (c) A = 1: Any increase in
derived in Coeurdacier (2009) and put is perfectly offset by
Kollmann (2006b) in the absence of the terms-of-trade. Bot
human capital risk (a —> 1). This term ties are perfect substitu
cancels out for a log-investor (er = 1). there is portfolio indeterm
As explained above (see equation 18), This is an extension of C
investors bias their portfolio toward Obstfeld's (1991) result,
equities that have high returns when
local goods are more expensive (if 4.1.3 Related Literature
a > 1). The appropriate portfolio Hedging Real Exchange Rate Ri
depends on the value of A i.e., on the \s appears clearly in the previou
elasticity of substitution (j). Three dif- optimal portfolios are structured t
ferent cases emerge: the risk arising from real exchan

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fluctuations. This is at the heart of the poten- coefficient of risk aversion is below unity
tial divergence of portfolios across investors (and equal to the inverse of the elasticity of
in the partial equilibrium portfolio choice substitution between the two goods), which
models with real exchange rate risk. The key allows to solve the model in closed-form,
issue is whether local equities are a good With such preferences, agents prefer to
hedge against relative price (real exchange hold local equities which pay less when local
rate) fluctuations, i.e., whether local equi- consumption is expensive. A similar point is
ties have higher returns when local goods made by Uppal (1993) in a two-country/one
are (relatively) more expensive. If this is the good model in continuous time with trade
case, then local investors should favor local costs: he shows that home bias only arises
equities. Early examples of this hypothesis for the coefficient of relative risk aversion
are Solnik (1974), Adler and Dumas (1983), smaller than one. One can potentially restore
Krugman (1981), Braga de Macedo (1983), the argument of Obstfeld and Rogoff (2001)
de Macedo, Goldstein, and Meerschwam in the present model if <x is above 1 but the
(1985) and Stulz (1981). Cooper and elasticity of substitution between goods <j)
Kaplanis (1994) start with the premise that is below unity. In that case, a fall in Home
for equity home bias to be rooted in a desire supply triggers a very large increase in the
to hedge against relative inflation, equity Home terms-of-trade such that Home equity
returns need to be positively correlated with returns are high when prices of Home goods
inflation. They test for such a correlation and are high. Hence, investors would rather hold
reject it for all countries considered. These local equities (see Kollmann 2006b). In this
early papers take relative prices (and the real class of models, equity home bias relies on
exchange rate) and asset returns as given the response of relative prices, i.e., on the
while in the present model and, more gener- elasticity of substitution between local and
ally in the recent Open Economy Financial foreign products. While time series macro
Macroeconomics, the dynamics of goods data estimating the response of trade to
prices and asset returns is endogenous, as is exchange rate changes suggests a low elastic
the covariance between the two. ity of substitution, between 0.5 and 1.5 (see
In the more recent literature, some con- Hooper and Marquez 1995, Backus, Kehoe,
tributions focus on the hedging of the rela- and Kydland 1994, and Heathcote and Peril
tive price of tradables (terms-of-trade, as in 2002), bilateral sectoral trade data suggests a
the present model) and some focus on the large elasticity—above 5 for most sectors (see
hedging of the relative price of nontrad- Harrigan 1993, Hummels 2001 and Baier
able goods. In their influential contribution, and Bergstrand 2001 among others).15 The
Obstfeld and Rogoff (2001) argue that trade parameter uncertainty makes it hard to get
costs in goods markets help to solve the a conclusive answer from this class of mod
equity home bias puzzle. The above model els. It is also important to note that output
(in line with Coeurdacier 2009)14 shows fluctuations in all these classes of models are
the opposite result for most parameter val- driven by supply shocks. In the presence of
ues (in particular for (j) and a above unity). demand shocks, equilibrium portfolios could
Indeed, in Obstfeld and Rogoff (2001), the turn out to be different: when local demand
14The model presented features home bias in prefer ISlmbs and Mejean (2009) claim that the discrepancy
ences instead of trade costs. A functional transformation of between macro and micro estimates comes from an aggre
trade costs would however make the two types of models gation bias; correcting for this bias, they find an elasticity
isomorphic. of up to 7.

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78 Journal of Economie Literatu re, Vol. LI (March 2013)
is high, both prices of local goods and pay- consumption together with multiple trad
offs of local firms increase. Hence, demand able goods (see Baxter, Jermann, and
shocks can generate positive comovements King 1998, Serrât 2001,16 Obstfeld 2007,
between local equity returns and the price Matsumoto 2007, and Collard et al. 2007).17
of local goods (see Pavlova and Rigobon In these papers, the presence of nontrad
2007). In order to be able to consume when able consumption interacts with tradable
demand is high, local investors would prefer consumption and some degree of home bias
local equities. in nontradable equities obtains. The precise
Similarly, the presence of nontradable structure of portfolios is strongly depe
consumption exposes domestic agents to real on preference parameters, in partic
exchange rate risk (driven by fluctuations substitution elasticities between
in the relative price of nontradable goods). and nontradable goods (and also
Stockman and Delias (1989) develop a two- domestic and foreign tradable go
country model with endowment economies. mechanism at the heart of the h
Each country has random endowments of a toward nontradable equity is howeve
(single) traded good and a nontraded good. tially similar to the one described in
There is trade in equities of tradable and vious model: investors want to hold
nontradable goods firm. With utility sepa- whose payoff is high when the real e
rabie in tradable and nontradable consump- rate appreciates, i.e., when the consu
tion, optimal portfolios imply that domestic of nontradable goods is expensive.
agents hold all of the equity of domestic out that for a sufficiently low elas
nontradable firms. By holding all of the substitution between tradable and
equity of nontraded goods, domestic agents able goods (roughly below unity as f
hold an asset whose return is perfectly cor- the empirical literature),18 a fall in
related with their expenditure on nontraded tradable output implies a strong
goods. Domestic agents hold the same share in the relative price of nontrada
of Home and Foreign equity of tradable together with an increase in local
firms, implying perfect diversification in the able equity returns: hence, local n
tradable sector as in Lucas (1982). Thus, this able equity returns comove positivel
model generates home bias in equity posi- the price of nontradable goods (an
tions, and the home bias increases in the exchange rate), leading to local equ
share of nontradable consumption in total in that sector.
output. Various papers have extended this On the empirical front, Pesenti
framework to more general preferences, Wincoop (2002) derive an express
investigating in particular the nonsepara- relates home bias to the correlation
bility between tradable and nontradable equity returns and nontradable con
1® See also Kollmann (2006a) for a comment. correlated with the price of the nontradable good and
l7In earlier work, Eldor, Pines, and Schwartz derive
(1988),conditions for the risk aversion parameter, the price
in a general equilibrium model, study n countries, elasticity
each of demand for tradable goods and the income
producing a nontradable good and the single tradableelasticity of demand for tradable goods such that it would
good that is consumed in all countries. The assetsbe the case.
traded
are "real equities" for the tradable and nontradable 18Typical
good. values used for the elasticity of substitu
Tradable equities pay one unit of the traded good tion
in eachbetween tradable and nontradable goods are: 0.44
state of the world, while nontradable equity pays(Stockman
out 9 and Tesar 1995), 0.74 (Mendoza 1995), from
0.6 to 0.8 (Serrât 2001). Ostry and Reinhart (1992) provide
units of the nontradable good, where 9 is state contingent
nontradable output. They point out that for homeestimates
bias to for developing countries in the range of 0.6 to
1.4. See Matsumoto (2007) for a more detailed discussion.
arise the returns of nontraded equities have to be positively

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growth19 and using data on fourteen OECD returns (over foreign) increase when the
countries from 1970 to 1993, they find real__exchange rate appreciates (the term
that, on average, nontradable consump cov(rer, d,) eqUayon As shown by van
var (d,) ^ J
tion growth is positively correlated with the Wincoop and Warn
return on domestic capital. This would imply correlation betwee
that home bias would arise if tradables and
and the real exchan
nontradable goods are complementary. The low to explain obse
authors find, however, that even in those Furthermore, mos
cases, hedging nontradable consumption the real exchange rat
could at best explain a relatively small frac in the nominal exc
tion of the home bias observed in the data.
in section 4.2, thes
Overall, there are two empirical difficulties positions in the forw
with an explanation of the equity home bias the currency bond
relying on the presence of a nontradable equities do not see
sector. The first one is that the structure of
appropriate asset to
portfolios is strongly dependent on prefer real exchange rate f
ence parameters, which are not easy to esti these models are the
mate. The second one is that the home bias
doubtful that the h
result relies on the ability of investors to hold rate risk can accou
separate claims on tradable and nontradable equity home bias.
output: as most products contain both trad
able and nontradable components, shares of
firms automatically involve joint claims on Hedging Nontrada
tradables and nontradables. This difficulty is
made all the more relevant by the fact that, In our model (see
when agents are allowed to trade separate nontradable incom
claims on tradable and nontradable output, stocks which have hi
optimal equity positions are very different income is low. The focus of the literature
across the two sectors. This different struc has been twofold: first, from a theoretical
ture of portfolios across traded and non perspective, it has discussed the conditions
traded sectors seems inconsistent with casual under which standard macroeconomic mod
empiricism as argued by Lewis (1999). More els imply a negative or positive correlation
broadly, empirical analysis of this channel between local equity returns and returns to
is also hindered by the difficulty to identify nontradable wealth. Second, from an empiri
precisely nontradable consumption and trad cal perspective, a series of papers have pro
able/nontradable equity. vided estimates of the covariance between
There is yet another major empirical issue relative equity returns and relative returns
faced by this explanation of home bias. The to human wealth which is the key empirical
hedging of real exchange rate risk leads to counterpart of portfolio biases in this class of
models.
equity home bias if local equities have higher
returns (than abroad) when local prices are The most influential contribution on these
higher (than abroad). In other words, equity matters is Baxter and Jermann (1997), who
home bias appears if excess local equity argue that the presence of nontradable
income risk worsens the equity home bias
19Their model also includes leisure, which drives puzzle. Their argument goes as follows: in
another hedging motive. a standard multicountry real business cycle

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80 Jou rnal of Economie Literature, Vol. LI ( Ma rch 2013)
model with a single tradable good and a assume that innovations to capital and labor
Cobb-Douglas production function, changes incomes are independent across countries.
in output are shared in constant proportion Once the misspecification is corrected,
between capital and labor. Hence, labor and considering human capital risk does not
capital incomes are perfectly correlated. unequivocally worsen the home bias puzzle.
As investors are already strongly exposed Using micro-level data, Massa and Simonov
to domestic risk due to their labor income, (2006) show that nonfinancial income is
they should not hold local capital. Due to uncorrelated with the market portfolio of
the relatively large labor share in all coun financial assets, but actual investors' portfo
tries, the effects of hedging domestic human lios (which differ from the market portfolio)
capital dominates the benefits of diversifica are more positively correlated with nonfi
tion: investors should short-sell local equities nancial income than the market portfolio is.
(term — in equation 20). Hence, the Thus, the authors cast doubt on the rational
equity home bias puzzle is worse than we ity of investors and on their desire to hedge
think! The authors estimate a vector error nontradable income risk.
correction model that allows the correlation From a theoretical perspective, Heathcote
between labor and capital returns to vary and Perri (2007) show that Baxter and
over time and be imperfect, while maintain Jermann's (1997) result relies on very strong
ing the assumption that the ratio of labor assumptions: one single and perfectly trad
to capital income is stationary. Using data able good and a fixed capital stock. Relaxing
from the OECD National Accounts (1994) those assumptions (in a two-countiy/two
for Japan, the United Kingdom, Germany, good international real business cycle model
and the United States for 1960-93, they à la Backus, Kehoe, and Kydland 1994) and
find that within countries, labor and capital introducing differentiated product across
returns are highly correlated, while the cor countries together with consumption/invest
relation between domestic labor returns and ment home bias changes drastically the pic
foreign equity returns is quite low. Using the ture and helps solve the EHB puzzle. Their
observed correlations, the authors then con result relies on two key elements: endog
struct diversified portfolios and find that the enous capital accumulation and a strong
optimal position in domestic equity is nega adjustment of relative prices.20 The main
tive in all the countries considered. intuition is the following. Suppose a posi
Their empirical findings have been chal tive (persistent) productivity shock hits the
lenged by a series of papers. Bottazzi, Home economy. This leads to:
Pesenti, and van Wincoop ( 1996) use a con
tinuous time VAR model of portfolio choice (i) a fall in the relative price of Home
and data on a large set of OECD countries goods (Foreign goods are scarcer).
and find that returns to domestic capital and
human capital are negatively correlated for (ii) an increase in Home investment
most countries but the United States and (more than abroad) as Home invest
this can explain a fraction of equity home ment uses more intensively cheaper
bias in these countries. Julliard (2002) Home goods (due to home bias in
argues that the Baxter and Jermann s ( 1997) investment spending).
empirical findings are due to an economet
ric misspecification: the correlation between
20 Endogenous capital accumulation is crucial: despite
returns to human capital and local equity multiple goods, Baxter and Jermanns (1997) results would
returns is overstated because they implicitly survive if capital is fixed.

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(iii) an increase in Home wages (more 4.2 Hedging Motives in a Benchmark Model
than abroad) and in the Home returns with Multiple Asset Classes (Bonds and
to nontradable wealth. Equities)
(iv) a decrease in the returns on Home 4.2.1 Hedging with Bond an

capital (relative to Foreign) if the The Role of "Conditional
(relative) price response of Home
goods is strong enough. The first generation of papers
above focus on equity positions to ration
The main difference with Baxter and home bias. However, equities
Jermann (1997) is the last point (iv): if the financial assets traded intern
market price of Home goods falls sufficiently securities (nominal bonds in
and Home investment is increasing, divi- cies, corporate bonds, bank
dends distributed by Home firms (which are instruments that can also b
net of investment) are lower than abroad, risks internationally (see
and so are Home returns to capital. Hence should not be excluded fr
the model generates negative comovements first for realism, since they c
between Home (excess) returns to human share of international asset
wealth and Home (excess) returns to capi- all because there might be subs
tal: hedging nontradable income risk implies asset classes. Hence, equity
home equity bias. Home bias in investment/ in equity only models migh
consumption spending is important as it the presence of other financial
triggers a stronger response of investment models with portfolio decisio
at Home, thus a larger fall of Home divi- porated multiple assets (equ
dends and a larger increase of Home wages. to have more robust and
Importantly, the model generates a positions.22 Nominal bond retur
tive link between consumption home bias across countries are (almos
and equity home bias as found in the data.21 related with the real exchan
Note that Heathcote and Perri (2007) focus oped countries, fluctuations i
on log-utility and unitary elasticity of substi- exchange rate account for m
tution between Home and Foreign goods. tuations in the real exchan
Increasing the level of risk aversion intra- bonds are better suited
duces a real exchange rate risk motive as in hedge real exchange rate risk
Coeurdacier (2009) and Kollmann (2006b). the end of the story. The p
Increasing the elasticity of substitution also affects the hedging pro
reduces the response of relative prices and ties for nontradable incom
makes the portfolio converge toward the one are used to hedge sources o
of Baxter and Jermann (1997). not be hedged through the b
in particular the part of nontradable inc
risk that is orthogonal to bond returns
21 Lane (2000), Aizenman (2004), and Heathcote and
22 As described in section 4.2.5, recent contributi
Perri (2007), among others, show a positive relationship
with multiple
between trade openness and foreign equity holdings look asset classes include Engel and Matsum
(2009a,
ing at a cross section of countries. Portes and 2009b), Coeurdacier, Kollmann, and Martin (
Rey (2005),
and Milesi
Aviat and Coeurdacier (2007), and Lane and 2010), Coeurdacier and Gourinchas (2011), Ber
and Bhattarai
Ferretti (2008) show that country equity portfolios are (2008), and Devereux and Sutherland (
strongly biased toward trading partners. and 2008).

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82 Jou rnal of Economie Literature, Vol. LI (March 2013)
this new literature, the optimal equity posi- Hence, preferences are now defined by
tion depends therefore on the correlation of
returns on equity with returns on nontrad- / çi-<?
71+w
' i,t vi,t
[i
able income, conditional on bond returns. (21) E0 Xi.t
(=0 \ 1 1+W;
4.2.2 Set-up of the Model
We use a similar set up as in section 4.1 but where Xut is an exogenous shock to the dis
we add two important ingredients to formal- tility of labor,
ize our above discussion on hedging motives:
endogenous capital accumulation and trade „ , , . , „ . , . , .
il j tl u , technologies ana Capital Accumulation
in real bonds, lhey allow us to overcome & r
the limitations of the model presented in As before, production in
4.1: first, endogenous investment in a two- capital and labor with
good model breaks the perfect link between duction function:
returns on physical capital and returns on
human capital; second, bond trading modi
(22) yu = 0u(ku)%t)i-".
fies the hedging properties of equities.
Bonds will be used to hedge fluctuations in
the real exchange rate. Equities will be used The law of motion of the
to hedge nontradable income risk, condition
ally on bond returns. This model is similar /<>o\ j /-i _
Coeurdacier, Kollmann, and Martin (2010), 1 ' M+1 ~1
which extends Heathcote and Perri (2007) to
multiple asset classes (bonds and equities). where 0 < 6 < 1 is the de
In presence of productivity shocks only, capital. Ilt is gross investme
we would face a portfolio indeterminacy in a date t. In both countries, g
first-order approximation of the nonportfolio generated using Home an
equations since the number of available assets
(bonds and equities in each country) would (24) Iit =
exceed the exogenous sources of uncertainty.
We have to add an additional source of uncer- [ûÔî. ()^-1^ + (1 —
tainty. We choose to add shocks to the disu
tility of leisure for simplicity. As explained in j f i,
Coeurdacier, Kollmann, and Martin (2010)
and Coeurdacier and Gourinchas (2011), the where ij ( is the amount
nature of the additional shock used to allé- investment in country
viate portfolio indeterminacy is irrelevant bias for investment spendin
for the portfolio and results would survive one for consumption),2
with other shocks commonly used (shocks to ciated investment price i
investment à la Greenwood, Hercowitz, and for consumption Pi t (see e
Huffman 1988, depreciation shocks, shocks
to capacity utilization . . . ).23
24 See Coeurdacier, Kollmann, and Martin (2010)

and Castello busi
23 Obviously, a different shock will have different (2009) for a model where bias in invest
ness cycles implications but we are presently ment
not spending
interested
is different from the bias in consumption
in those.
spending.

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Finns' Decisions the Home (Foreign) good in all future peri

ods. Both bonds are in zero net supply. We
A share 1 — a of output at market prices denote by S|t+1 the number of shares of
is paid to workers as in equation (6). A share
stock j held by country i at the end of period
t, while Bj t+i represents claims held by
a of country i output, net of physical invest
ment spending is paid as a dividend di tcountry
to i (at the end of t) to future uncon
shareholders: ditional payments of good j. At date t, the
country i household now faces the following
(25) di t = api tyi t - Fitlit. budget constraint:
(28) Pit Cit + pi j SiJ+l + pjj Sji(+i

The firm chose Ii t to equate the expected
future marginal gain of investment to the
marginal cost. This implies the following + pf t ®j,t+1 + Put B'i,t+1
first-order condition:25
= ™i,t kt + Ki + Pm)sm
(26) Pu = PEt[(CKt+l/Cur(PjPu+l)
+ (dj,t + plt)S'j,t
ipi.t+fi,t+laî',t+j'ij+l T (1 — ^)f¡,t+l]]
+ ('Pu + Put)B\,t
The firm chooses the Home and Foreign
investment inputs i\j,i\t that minimize the + (Pj.t + pf,t)B'j t, j i,
cost of generating Ii t. This leads to the fol
lowing intratemporal allocation for investwhere pft is the price of stock i and p it is the
ment goods: price of bond i.
(27) = Household Decisions and Market

Clearing Conditions
ij.t = (1 - ^ h*> J^L Households' first-order conditions for that

decision problem are still given by (9) and
Financial Markets and Instantaneous (10). One needs to add the Euler equations
for the two bonds:
Budget Constraint
There is now international trade in stocks (29) 1 = P"+1 + PJJ+1
and (real) bonds. Stocks in country i rep Cu ) Pj.t+i pft
resents a claim to its stream of dividends for j = H, F.
{di t}. There is a bond denominated in the
Home good, and a bond denominated in the Market-clearing in goods and asset mar
Foreign good. Buying one unit of the Homekets now requires:
(Foreign) bond in period t gives one unit of
(30) CHt + CHt + ÍHt + ÍHt = yHt,
25 Note that we use the intertemporal marginal rate cF,t + cF,t + ip.t + îf,i — Vf,o
of substitution of the country i household for investment
decisions in country i. This assumption is however irrele
vant here since up-to the degree of the approximation, the (31) Shj + Shj = Spt + Spt = 1,
intertemporal marginal rate of substitution of the country i
household and the countryj household are the same. BHHj + BFHJ = BFFtt + BHKt = 0

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84 Jou rnal of Economie Literatu re, Vol. LI (March 2013)
4.2.3 Zero-Order Equilibrium Portfolios where
As in section 4.1, equilibrium portfolio H = <j){\ — (2a - l)2) + (1 - s,) > 0

pi J pi J
holdings (SJi(+1,Sjjt+1,B}ií+1,Bjií+1) can be and s¡ = p— = p~ is the steady-state invest
determined by linearizing the model around ment/GDP ratio.
its deterministic steady state. With the asset
structure here (four assets with four exog Not surprisingly, Home terms of trade
enous shocks), efficient risk sharing can be worsen when the relative supply of Home
replicated up to the first-order (locally com goods increases, for a given amount of rela
plete markets). tive Home country investment. Home terms
of trade improve when Home investment
rises (due to home bias in investment spend
Linearization of the Model
ing), for a given value of the relative Home/
We use the same notation as in section 4.1. Foreign output.
Equations 13 and 14 still hold. Ex ante symmetry implies that the zero
Linearization of the relative demand for order portfolios have to satisfy the following
iH + iF conditions: S = S" = SFF = 1 — S# = 1 — Sp;
investment y¡ t = -ff—ff~ gives (using the B = Bg = Bff = -Bfh = —B". The pair (S;B)
lF,t + lF,t
intratemporal allocation across investment thus describes the (zero-order) equilibrium
goods (27)): portfolio. B denotes a country holdings of
bonds denominated in its local good. B > 0
(32) yft = -</>( 1 - (2a¡ - l)2) qt + (2a -1)4 means that a country is long in local-good
bonds (and short in foreign good bonds).
As before, there exists a unique portfo
where It = hi, t/IF i is relative real aggregate lio (S; B) that satisfies the following "static"
investment. Holding constant the terms of budget constraint, for consumptions that are
trade, the relative demand for Home invest consistent with the linearized risk sharing
ment goods, yI t, increases with relative real condition (14):
investment in the Home country, It, since
Home aggregate investment is biased toward (35) PutCit = wulu + Sdit
the Home good (a > 4.
The relative demand for consumption + (1 - S)dj t + B(pi t - pj,t),
yft is still defined by (from (15)):
for i = H, F.
(33) yc t
0(1- (2a - l)2) + (2u - l)2i <h Country is efficient consumption spending
at date t equals date t wage income, wi tli t,
= - A qt. plus the financial income generated by the
portfolio (S; B).
The market clearing condition for goods Subtracting the "static" budget constraint
(30), together with (32) and (33) implies: of country F from that of country FI and lin
. . .
eanzi
(34) (1 ~si)y^t +s,tfft
26We
= ~nqt + s¡(2a¡ - l)ît = yt, in the

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(36) (1 — s¡)(PH,tCH t — PFjCF t) income risk (totlt). Each portfolio (S and

b) is structured such that investors exploit
= (1 - s7)(l — -ij (2a — 1 )qt covariances of the assets payoffs with the
' two sources of risk. However, there is a key
RER, difference with the previous model with
equities: the covariance of asset payments
= (1 — a)wtlt + (2 S — l)(a — s¡)dt
with the real exchange rate risk and labor
_ income risk is conditional on payments of
the other assets. This finding has two main
where h = § denotes holdings of debt de- real exchange rate hedgin

nominated in local good, divided by steady- via the bond posiüon since bond re
state GDP. ferentials across countries are almos
fectly correlated with the real exchange rate
Partial Equilibrium Zero-Order Portfolios (see Coeurdacier and Gourinch
In the present model with real bonds, the
Like in the previous model, one can derive correlation is perfect and the rea
from the "static" budget constraint (36) a par- rate hed ¡ term Qn
tial equilibrium portfolio that expresses the /„ /7vrtTr 7, ,, 7 ,7\\ , ,
, i ? . .1 . p \ . I CovdRERt, d,)/VarriaJ will be exactly
hedging terms in terms of covariance-van- V ' ' 1 > J
ance ratios. This expression holds in a large ' n , ., ,, . r, ,
, r 11 -, i , 1 .1 .,. 0 Second, while the covariance of focal equity
class of models with bonds and equities. , . , 11111
,, . ,. f /0... j- 1 A . ,, returns with returns on nontradable wealth
Projection of (36) on a, and <7, gives the , , , ,
c „ J. . c o ,r i- r can be positive (as m Baxter and lermann
following expression tor the porttoho of , ,f. , . ,. . r /
1 , °i r ... /r , i r 19y7), this has no implication tor the equity
bonds and equities (S, b): r ,. , , r . n. . , J
1 porttoho, only the covariance conditional on
/ ~~j 7\ bond returns matters. As discusse
1 — n COVMlOtlt,Ut) 111 11
(37) S = - 1 —1 SI 1 turns out that the latter tends to be negative
2
a S' Var¿j(dt) in the data.
1 -Sj\ CovfRERt,dt] General Equilibrium Zero-Order Portfolios
+
b4) 01 S/ ' Varfdt) <P We now turn to the zero-order portfolio as
a function of the model parameters. Relative
(38) b = -
I i \ Cov~d(RERt,q~t) labor income (wtlt) is still given by: wtlt
2 (1 — sí)\^ ~ 7r j VîiWTTÏ = 9t Ûr Due 1° the presence of endog
Var-d(qt)
enous investment, relative dividends (dt) are
now given by (using (25)):
Co\¿{wtlt,qt)
(1-0;
Var'd(qt) (39) dí = ^^(qt + y¡)
where Covjj(£;, i/() is the covariance between a si ' HJ u,t FJ F'^

xt and yt conditional on the pay-off zt. a
a -,Mt + yt)
The bond and equity portfolios depend on
the hedging
L11V_- W1 of theIVV
Uit/ two U
sources of risk:
JUUIPC/J U1 real
1 ijlv. 1UCU ^
exchange rate risk and nontradable ot — ((2a - 1 )qt + It).

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Hence, using (34), we can reexpress (36) as hedging of nontradable income risk
follows: conditionally on bond payments: this
term is unambiguously positive and
(40) (l-Si)(l-l)(2a-l)$ drives home equity bias in the model.
To understand this term^ assume a
= [(1 - a) + a(2S - 1)]((1 - n)qt combination of shocks (6t, xt) such
that relative investment I, increases
+ s,(2a-l)ît) but leaves the terms-of-trade (bond
payments differential) q¡ unchanged.
-Sl(2S-l)[(2a-l)qt + ît] + 2bqt. Such a combination of shocks will
increase labor demand and labor
The asset structure supports full risk sharing, incomes since investment spending
up to first-order, if (40) holds for all realiza is using more intensively local goods
tions of the two (relative) exogenous shocks (a > 1/2).2' In the mean time, divi
(6t, Xt)- To solve for that portfolio, we do not dends net of investment spending
have to solve for output and investment, as are falling. This generates negative
a unique pair of terms of trade and relative comovements between labor income
real investment (qt, It) is associated with each and dividends holding relative prices
realizations of (6t, xt). constant (or equivalently conditional
The following portfolio (S, b) ensures that on bond payments differentials).
(40) holds for arbitrary realizations of (q~t, lt) :
The equity portfolio is the same as in
Heathcote and Perri (2007)28 but holds for
(41) S = |
l + (2a- 1)(1 - a)
1 - (2a - l)a H all values of the preference parameters. In
their benchmark case, parameters are such
that o — — p — 1. In that case, only fluc
(42) b = i (l-Si)(l-l)(2fl-l) tuations in investment matters for the equity
portfolio, for two reasons: (i) fluctuations in
(1 - a) [n - l+sI{2a1 - l)2] output are hedged through terms-of-trade
+ movements (as in Cole and Obstfeld 1991)
1 — (2 a — \)a
due to p = 1; (ii) £7=1 cancels out any
real exchange rate hedging term. As a con
The equity portfolio features home bias sequence, the equity portfolio is the same
and is the sum of two terms only. The hedg as in the present model. In contrast to the
ing-term for the real exchange rate is indeed
equities-only model, the equity portfolio in
zero in this model since relative price moveour model with bonds and equity is remark
ments are fully hedged by the appropriate ably stable to changes in preference parame
(real) bond position (cross-country differenters (see Coeurdacier and Gourinchas 2011).
tials in bond payments are perfectly correThe bond portfolio h is also the sum of two
lated with the real exchange rate). terms:
(i) The first term | is still the Lucas (1982)

27 Note that with a = 1/2 , this term is equal to zero since
term which prevails in the absence of increases in domestic investment changes do not increase
nontradable income risk (a —* 1) more domestic demand than foreign. Wages increase as
much in both countries.
28They consider the same model but with equities and
(ii) The second term ^ 7.°^ is the
I — (za — 1 )ot. productivity shocks only.

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(i) The first term-|-(1 — sz)(l — f){2a — 1) wtlt and relative dividend deviations dt for
is the hedging of real exchange rate each country with respect to the other six
risk. This is the desired exposure to countries (wages are computed for each
real exchange rate in the absence of country as the share of output going to labor
nontradable income risk (a-> 1). and dividends are computed as the share of
This term is unambiguously positive output going to capital net of investment
since local bonds have higher payoffs spending).30 Deviations are either first-dif
when local goods are more expensive. ference of the variables or HP-filtered data
(smoothing parameter 1600). We compute
(ii) The second term (1 ~ a\^ ~ l + s,(2a' ~i; I
w 1 - (2a - l)o bond payments differentials q using the
is the hedging(trade-weighted) real exchange rate of one
of nontradable i
risk conditionally on to
country with respect the other six. Note div
relative
payments: that results
this term are virtually
can the same
be when
posit
negative. Roughly using nominal exchange
speaking,rate instead of the it
ative if relative wages are real exchange rate (i.e., considering nominal
posi
(resp. negatively) bonds instead of real bonds). We also report
correlated wi
terms-of-trade, which the unconditional çovariance-variance
happenratio
low values of (Cov(wtlt,
p, dt)/Vax(dt)
i.e.,), the low one that matter
elastic
substitution (f) (resp. for in an equity-only model (see equation 18). As
high
shown
of /i, i.e., high elasticity of su in table 2, conditioning for exchange
tion 4>). rate movements has a strong impact on the
hedging properties of equities for nontrad
4.2.4 Empirical Evidence on the Hedging able income risk: unconditionally (lines 1
of Nontradable Income Risk and 3), wages and dividends comove posi
tively for all countries, which would lead to
In order to show the relevance of condi a large foreign equity bias in the equity-only
tioning for bond returns, we now present model of section 4.1. Conditionally (lines 2
some empirical evidence on the hedging of and 4, wages and dividends comove nega
nontradable risk (see Coeurdacier, Kollmann,tively for all countries, which lead to a home
and Martin 2010 for similar evidence29). Theequity bias in our equity-bond model. The
evidence is based on the expression of the presence of bonds makes the international
portfolio in terms of variance/covariance diversification puzzle better than you think,
ratio (equation 37) both in the model and in the data!
We use national accounts data for G7
4.2.5 Related Literature
countries to compute the conditional covari
ance-variance ratio {Co\';¡(wtlt, c/()/Var-(<7())Coeurdacier and Gourinchas (2011) show,
for each country. Data are quarterly overin a two-country, two-good, two-period
the period 1980Q1-2008Q3. Data are taken endowment economy with trade in equities
from OECD National Accounts Data and and bonds, how bond trading cast doubt on
from the IFS for exchange rates and priceearlier findings of equities only models. They
indices (see Coeurdacier and Gourinchas
show that in many theoretical environments,
2011 for a precise description of the data). We
compute relative labor income deviations
30We follow Gollin (2002) to allocate mixed-incomes
from the national accounts to labor or capital. We assume
29 In a revised version, Heathcote and Perri (2007) alsothat the share of mixed income going to labor is equal to
provides similar empirical evidence. the share of labor income in value added.

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Journal of Economie Literature, Vol. LI (March 2013)
TABLE 2
The Hedging of Nontradable Risk: Conditional and Unconditional Covariance-Variance Ratios
CA FR GE IT JP UK US
(1) Cov(wtlt, dt)

0.16 0.28 0.32 0.58 0.42 0.49 0.37
Var (dt) (0.041) (0.064) (0.067) (0.065) (0.052) (0.057) (0.065)

(2) CoVqiwtlf, dt)
-0.015 -0.128 -0.095 -0.076 -0.080 -0.122 -0.051
Varq(cft) (0.014) (0.015) (0.025) (0.030) (0.019) (0.026) (0.020)

(3) Cov(wtlt, dt)
0.08 0.47 0.33 0.33 0.46 0.39 0.55
Var (dt) (0.035) (0.085) (0.073) (0.031) (0.045) (0.043) (0.075)

(4) Cov^(u:t lj, dt)
-0.032 -0.139 -0.135 -0.011 -0.097 -0.084 -0.070
Vaiq(dt)
(0.009) (0.023) (0.031) (0.015) (0.015) (0.018) (0.022)
Notes: (1) and (2): in first-difference; (3) and (4): HP filter. Standard errors in parentheses.
Sources: Authors' computations. OECD National Accounts Statistics and International Financial Statistics.
bonds are an excellent hedge for real fluctuations are related to real exchange rate
exchange rate fluctuations. They provide evi- fluctuations and the forward positions are
dence in line with table 2 based on returns used to hedge the nominal exchange rate
data. Using data on G7 countries, they show changes, leaving only a part of the relative
that the unconditional correlation between price risk to be hedged by equity positions,
returns on equity and returns on nontradable The authors show that sufficient degrees of
wealth is very different from the conditional price rigidity can generate substantial home
one: while the former is positive for all coun- bias in equity positions, as domestic returns
tries (as in Baxter and Jermann 1997), the to human wealth and domestic equity
latter is negative (or nonsignificant) for all returns are negatively correlated, conditional
countries, rationalizing the degree of home on nominal exchange rate changes. With
bias observed in G7 countries. Their findings monopolistic competition and price rigidi
echo the empirical results of van Wincoop ties, output is partly demand determined in
and Warnock (2010) who show that equities the short run. Following a local positive pro
are a very poor hedge for real exchange risk, ductivity shock, labor demand falls. Wages
and even more so when trade in nominal also fall, leading to a fall in domestic labor
bonds (currency forwards) is allowed. income. Mark-ups and profits increase, as,
A similar theoretical point is made in for the same level of production, labor costs
Engel and Matsumoto (2009a) in the spe- go down. As price rigidities become smaller,
cific case of a two-country/two-good DSGE we have two effects lowering home bias,
model with monopolistic competition and Firstly, prices fall more following a posi
sticky prices. Assets traded are domestic tive productivity shock, increasing output
and foreign equity and positions in currency and pushing up labor demand and wages,
forward markets (which are equivalent to Secondly, the nominal and the real exchange
nominal bonds). Uncertainty is driven by pro- rate become less closely related, making
ductivity shocks and money supply shocks. forward contracts less able to hedge fluctua
Due to price rigidity, nominal exchange rate tions in relative prices. In the extreme case

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of full price flexibility, we go back to Baxter bonds and equities, in the case of bond trad
andjermann (1997): labor incomes and prof- ing only, there is an additional motive for
its are perfectly correlated and investors do price stability. With price stability, cross
not take any forward position as they do not country nominal bonds returns differen
want any exposure to purely nominal risk. rials become more correlated with the real
Engel and Matsumoto (2009b) generalize exchange rate, which improves international
the results above to the cases of local bias risk sharing.
in consumption, producer currency pricing, Lastly, Berriel and Bhattarai (2008) solve
and wage rigidity. for equity and nominal bonds portfolios in
Rabhari (2009) develops a two-country a standard two-country general equilibrium
DSGE model with price stickiness, endog- model in presence of government spending
enous capital accumulation, trade in nominal shocks and nominal shocks (shocks to the
bonds and equities, and endogenous mone- price level): they investigate a new source
tary policy. In his setting, equity home bias is of nontradable income risk, namely tax
again driven by the motive to hedge human changes. In order to hedge fluctuations in
capital risk. Real exchange rate risk is mainly taxes, households exhibit home bias toward
hedged through bond positions due to price local (government) nominal bonds and local
stickiness. He also shows that the combina- equities. The main mechanism goes as fol
tion of price stickiness and endogenous capi- lows: price level shocks at home (increase
tal accumulation can produce relative equity in home inflation) lowers the value of home
returns that are unconditionally positively government debt and the government can
correlated with human capital returns, but lower taxes (while still satisfying its intertem
conditionally negatively correlated (control- poral constraint). Hence, returns on domes
ling for bond returns). This correlation pat- tic nominal bonds and local taxes comove
tern is confirmed using U.S. data. positively and the household prefers to hold
Devereux and Sutherland (2007, 2008) local nominal bonds. Government spending
develop a two-country, two-good DSGE shocks lead to an increase in taxes. In the
model with nominal rigidities à la Calvo, meantime, as government expenditures are
producer currency pricing, and endogenous biased toward local goods, the relative price
monetary policy. The monetary authority of locally produced goods increase and so
sets the nominal interest rate in response to does the pay-off of the claim to local output
changes in producer price inflation. There (local equity). Hence, returns on local equity
is no local bias in consumption and produc- and taxes comove positively and households
tivity shocks are assumed to be persistent. will optimally bias their portfolio toward
The authors consider different asset market local equity.
structures (portfolio autarky, trade in nomi- . „ „ t ,
, , , i i . -il i i 4.3 Extensions and shortcomings
nal bonds and trade m nominal bonds and °
equity). They can generate home bias in

equities tor the same reason as Engel and
Matsumoto (2009a). They also find th
monetary policy assumes an additional role
in these models. By changing the returns o
nominal bonds, monetary policy affects po
folios and thus risk sharing. Interestingly
they find that while monetary policy has n
impact on portfolios with trading in nomin

210.12.45.98 on Tue, 05 Apr 2022 02:31:57 UTC
to bonds and equities instead of considering financed through debt, holding the same
an even larger set of assets. There is no sim- fraction of debt and equity guarantees that
pie answer to this question: potentially any investors have their optimal exposure to the
asset that is traded publicly could affect the value of the firm. One shortcoming though
equity portfolio if it has some hedging prop- is that such a result might not hold if the
erties in addition to what bonds and equities Modigliani-Miller theorem does not apply
can achieve. Note that the empirical tests or if financial markets are incomplete. We
of these hedging properties based on cova- are not aware of any models that pins down
riance-variance ratios could be potentially international portfolios in a world where the
extended to a larger menu of assets, one just financial structure of firm, optimal or not,
needs to condition for returns on these other affects the value of the firm and matters for
assets. In particular, including housing as an the real allocation.
additional asset seems a natural extension of . „ » „ , ,. , T, .
, 4.3.2 Exchange Rates and Asset Prices
existing work. °
A related question is the r
rate debt in these models. W
debt as a way to raise capital f
have focused on firms that ar
through equity. Coeurdacier
Martin (2010) tackle this issu
for an exogenous financial str
in a world of "locally compl
They show that, in an environm
financial structure is irrelevan
of the firm (when the Modigl
theorem applies), the presence
debt has no impact on investm
and the equilibrium consump
tion (up to the first order) sin
complete. Moreover, the equili
portfolio is also not affected b
of corporate debt. They show
investors will hold a fraction
debt issued by domestic firm
the fraction of stocks of the
they hold. Hence, if the mode
fias in equity, it will also deliv
in corporate debt in the sam
The reason is simple: when th
Miller theorem applies, invest
tain exposure to the total valu
which is independent of its fi
ture. In particular, the fraction
the firm they hold optimally
in the case where firms are
through equity. When firms a

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risk-sharing is replicated, or at least up to the and Perri 2007 are notable exceptions: in
degree of the approximation. This implies an line with model predictions, they match the
equality between the ratio of marginal utili- degree of equity bias to the degree of trade
ties of consumption and the real exchange openness of countries). Since more data on
rate in all states of nature. With standard aggregate foreign asset holdings are now avail
CRRA preferences, this leads to a perfect able, both in the time series and in the cross
correlation between real exchange rate section, it seems natural to extend theories to
changes and relative consumption growth heterogeneous countries. This would provide
(Home relative consumption falls when more accurate tests of the different theories
Home relative prices are higher; see equa- available. Exploiting the bilateral dimension
tion 14 in the previous models). In the data, of the data using a multicountry framework
this is strongly rejected, the correlation is could also help in that matter. Indeed, using
close to zero and if anything Home relative the CPIS data provided by the IMF since
consumption increases when Home relative 2001, one can now observe equity holdings
prices are higher: this is the famous consump- between country pairs. Most of the theoreti
tion-real exchange rate anomaly (Kollmann- cal literature has so far limited its attention to
Backus-Smith puzzle; see Backus and Smith models with two symmetric countries, which
1993 and Kollmann 1995). In the previous does not allow to exploit the bilateral and
models, the asset structure and the dimen- cross-sectional variations of the data,
sion of uncertainty are such that one can A similar point can be made regarding
replicate the efficient allocation (up to first the currency exposure of international port
order). One could believe that adding addi- folios. As shown by Lane and Shambaugh
tional sources of uncertainty such that mar- (2010a, 2010b), the currency denomina
kets are incomplete even locally would help tion of foreign assets and liabilities are very
to solve the consumption-real exchange rate heterogeneous across countries. While,
anomaly. It turns out to be extremely hard on average, the advanced countries are (in
to lower the correlation between relative net terms) borrowing in foreign-currency,
consumption and the real exchange rate in some major countries have very large nega
models with endogenous portfolio decisions tive domestic-currency debt positions (most
despite imperfect spanning of risks (see notably the United States). Models includ
Coeurdacier, Kollmann, and Martin 2008 ing bond positions denominated in differ
and Benigno and Kûçiik-Tuger 2008). In ent currencies should be also tested against
most existing models with endogenous port- such data. In section 7, we also provide some
folio choice, international risk-sharing is still evidence on the cross-sectional dispersion of
far above what consumption data suggests home bias for other asset classes (bonds and
and this remains an important challenge for banking assets),
future work.
4.3.3 Dispersion of Home Bias across Time, 5. Asset Trade Costs in International
Countries, and Assets Financial Markets
Data on home bias exhibit substantial vari- So far, we ha
ations across time and across countries (see motives as a source
figures 1 and 2 and table 1). Most of the work folios assuming fr
has been dedicated to match the average Another strand of
degree of home bias observed in developed ature considers fric
countries (Collard et al. 2007 and Heathcote as the main source

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investors. Portfolio home bias is the natural hundred basis points, too big to be true!
outcome of these frictions. Such frictions Numerous subsequent studies have provided
could include fixed or proportional transacsuch indirect estimates of the costs. Jeske
tion costs in foreign portfolio investments, (2001) calculates the implicit costs on foreign
difference of tax treatments across domes assets necessary to skew the portfolio alloca
tic and foreign portfolio incomes and other tion away from the optimal (based on a mean
policy induced restrictions on foreign invest variance model) toward the observed alloca
ments (such as limits to foreign investment, tion. These costs are very large ranging from
capital controls, differences in legal frame 150 to 700 basis points across countries. Most
works) (see French and Poterba 1991, Lewis studies are in line with French and Poterba's
1999, and Dahlquist et al. 2003). Other (1991) results and argue that costs need to be
important frictions to international invest very large to explain portfolio holdings (see
ments are informational frictions. The role of Cooper and Kaplanis 1994, among others). A
information has been extensively investigated notable exception is Sercu and Vanpée (2008)
in the finance literature but less so in the who find that, once they control for many fac
Open Financial Macroeconomics literature
tors (currency risk, inflation hedging, fixed
(Hatchondo 2008; Tille and van Wincoopinterest investments, round-tripping, and
2009; and Dumas, Lewis, and Osambela omitted countries) and allow for time varying
2011 are recent notable exceptions). For this covariances, the implicit inward investment
reason, we will review the literature on infor costs are much lower than in earlier studies
mational frictions (and behavioral biases) in in developed markets (in the order of magni
a separate section (see section 6). tude of 0.10-0.20 percent per annum). It is
however important to note that the associated
5.1 Transaction Costs Would Need to Be Very costs estimated from stock returns data suffer
Large to Explain Equity Home Bias . . .
from potential statistical uncertainty: due to
There is a wide debate on the importance of the high volatility of stock returns, estimates
transaction costs to explain international port of expected returns based on past data are
folio decisions. French and Poterba (1991) imprecise. Hence, when testing whether opti
initially argue in a mean-variance framework mal portfolios weights are statistically differ
that these costs must be much larger than the ent from the observed ones, results have been
one typically observed if one wants to rational quite inconclusive (see Bekaert and Urias
ize equity home bias. Using stock returns data 1996, Gorman and Jorgensen 2002, Britten
from 1975 to 1989 for the United States, Japan, Jones 1999, and Lewis 1999, among others).
the United Kingdom, France, Germany, and In other words, estimated costs to rationalize
Canada, the authors use estimates of a covari portfolio allocations have large standard errors
ance matrix of returns together with an opti and in many cases one cannot reject that the
mal portfolio rule that is implied by constant observed home biased portfolio allocation is not
relative risk aversion in order to back out the statistically different from the optimal one.31
differences in expected returns needed to
explain actual portfolio shares for these coun
tries. The implicit excess return on domestic 31Pástor (2000) goes one step ahead and exam
ines whether an investor that updates his views on the
equity implied by observed portfolio holdings distribution of domestic and foreign returns in a Bayesian
is then interpreted as a measure of the cost fashion may choose a strongly home biased portfolio. This
of international asset trading needed to gen will be true if the investor holds a strong biased prior
toward the domestic asset. But greater uncertainty on for
erate the observed home bias: they find an eign stock returns can induce him to pay more attention to
order of magnitude for these costs of several the data and move away from this prior.

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Coeurdacier and Rey: Honie Bias in Open Economy Financial Macroeconomics 93
Another piece of evidence pointing that marginal utilities—the complete market out
transaction costs cannot rationalize portfolio come. It is worth noting, however, that this
holdings is Tesar and Werner (1995): trans argument implies that a portfolio would be
action costs based explanation of the equity indeterminate if trade in equities were pos
home bias should in general imply that sible since home and foreign stocks would be
turnover should be lower for foreign equity perfect substitutes. Cole and Obstfeld (1991)
holdings than for domestic ones (unless they show that the equivalence between portfolio
apply only to dividend repatriation). Tesar autarky and complete markets also obtains in
and Werner (1995) find that turnover is in a setting with investment under the follow
fact higher for foreign holdings.32 ing assumptions: (i) unitary elasticity of sub
stitution between the two goods, (ii) unitary
5.2 ... Unless Diversification Benefits Are
elasticity of intertemporal substitution, and
Very Small
(iii) full depreciation. For the no-investment
As stated above, transaction costs are often case, the authors calculate welfare gains of
assumed to be small although direct mea moving from autarky to perfect international
sures of these costs do not often exist (see risk-sharing. They find small welfare gains
below). However, as shown by Martin and for a broad range of values of the elasticity
Rey (2004) and Coeurdacier and Guibaud of substitution between the two goods. Since
(2009), even small transaction costs may the seminal paper of Cole and Obstfeld
lead to sizable home bias when Home and (1991), a large number of papers using con
Foreign stocks are close substitutes: any
sumption data have computed welfare gains
small transaction cost is amplified if the ben from international risk sharing with quite a
efits of diversification provided by foreignlot of variation across studies. Van Wincoop
assets are small. (1999) documents the extent to which the
Indeed, small diversification benefits is results
a are strongly sensitive to assumptions
crucial ingredient for the transaction costsabout preferences (the coefficient of relative
based story to work. A key contribution in risk-aversion and the elasticity of substitu
this literature is Cole and Obstfeld (1991),tion between traded and nontraded goods),
the assumed "autarky" consumption pro
who show in the context of a two country/two
cess, the implicitly chosen risk-free interest
good model that gains from international risk
sharing are probably quite small, as changesrate and the horizon of calculations. Without
in the terms of trade help to share risk interclosing the debate, he tries to narrow the
nationally even with portfolio autarky. The range of reasonable estimates and does find
intuition is simple. Assuming Cobb-Douglassignificant gains from risk sharing among
preferences over the consumption of the twoOECD countries over a long horizon: 1.1 to
good, an increase in local output triggers 3.5 percent of permanent consumption for a
an equivalent fall in their relative prices asfifty-year horizon, and 2.5 to 7.5 percent for
local goods are now more abundant (termsa one-hundred-year horizon.
of-trade adjustment). In this economy port Overall though, explicit consumption
folio autarky implies perfect correlation of based calculations of the welfare cost of
underdiversification tend to imply low costs.
These results are very often driven by the
low
32 Rowland (1999) and Amadi and Bergin (2008) con variability of consumption in the data.
struct models that can generate higher turnover for In contrast, costs of underdiversification
foreign
asset holdings than for domestic ones, in the former case
with proportional trading costs, while the latter use fixed
based on stock returns data are usually much
trading costs. larger, due to the much larger volatility of

210.12.45.98ffff:ffff:ffff on Thu, 01 Jan 1976 12:34:56 UTC
stock returns. This point is clearly made by The question of the role of international
Lewis (2000): she finds that moving from taxation also remains opened. For simplicity,
portfolio equity autarky toward an optimally we abstract from taxation issues within mul
diversified portfolio (efficient frontier in a tinationals and the effects on international
mean-variance framework with a relative taxation on Foreign Direct Investment and
risk aversion of 2 leads to a gain of 10 to focus on the taxation of portfolio incomes.
30 percent of current wealth while moving When considering the rules of international
from autarky consumption to perfect inter- taxation, one could expect some large impact
national risk-sharing leads to an increase on home portfolio biases. First, dividends
in permanent consumption of less than 1 when repatriated are subject to non-negli
percent. The gap between the two metrics gible withholding taxes (of a magnitude of
remains an open question; one will need to roughly 10 percent in developed countries),
reconcile risk-sharing gains using consump- Even if many bilateral tax treaties lead to
tion and asset prices data to fully evaluate the some exemptions of these withholding taxes
impact of transaction costs on international (through tax credits schemes), this is not true
portfolios. for all investors and these exemptions are
Finally, another argument in the litera- often subject to some ceilings. S
ture has been that domestic multinationals developed countries have di
already provide benefits of diversification tion schemes: capital income
by being active in many countries, reduc- indeed taxed twice in most coun
ing the gains from international diversifica- corporate tax level and at the i
tion. However, Lewis (1999) and Rowland (when profits are distributed
and Tesar (2004) argue that the correlation ers). To avoid this double-t
between the returns of multinational and holders receive a tax rebate. The tax rebate
their national stock indices is quite high, thus is such that, on net, investors end up paying
limiting the diversification benefits they can the income tax only. Such dividend imputa
actually offer. tion schemes do not apply to foreign asset
_ „ r, „ , ., holdings. This drives an additional significant
5.3 Direct Measures of the Costsr i.rr ,. , . ,, .. r . ,?
J dnlerential in the taxation ot capital incomes
It is important to note that most existing coming from domestic or foreig
work provides indirect measures of trans- Gordon and Hines 2002 and
action costs using stock returns data and of the Griffith, Hines, and S p
observed portfolio allocation (as in French for excellent surveys). Howev
and Poterba 1991). There are no papers we by Gordon and Hines (2002), t
are aware of that presents an extensive mea- ferentials might not be effecti
sure of actual costs in investing in foreign since this is very difficult for gov
assets. While directly observed transaction enforce the taxation on foreign a
costs on the stock markets are typically very Tax evasion on income from fo
low, they might not be the appropriate mea- ties through foreign financial
sure for these asset trade costs. For instance, ies (in tax havens in particular)
most households go through financial inter- issue if one wants to measur
mediaries to invest in stock markets (pension costs associated to internationa
funds, mutual funds . . . ) but there is so far Hence, while most papers tend
very little empirical evidence investigating taxation differentials between do
the difference in fees collected for foreign foreign asset incomes cannot ful
investments compared to domestic ones. for the size of portfolio biases, it re

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hard to provide a quantitative estimate of chasing" effect in the data. Brennan et al.
their impact on portfolio decisions. Studying (2005) extend their initial work by developing
optimal taxation of capital in a model where a noisy expectations model where investors
home bias is endogenous would be a very nat receive public and private information sig
ural extension of the literature. Gordon and nals. The private signal is less precise for for
Gaspar (2001) provide an interesting treat eign investors. The authors show that there
ment of optimal tax policies in a partial equi is a link between information disadvantages
librium model where home bias in equity or and the expectations (degree of bullishness)
bonds is endogenously generated. about a market: foreign investors tend to
become more bullish about a certain market
following a positive return on that market.
6. biformational Frictions and
Behavioral Biases Glassman and Riddick (2001) quantify what
should be the perceived riskiness of foreign
assets (due to lower information quality) in
6.1 Informational Frictions
order to generate the observed home bias
of U.S. investors. They find that investors
6.1.1 Exogenous Information Sets
would have to scale up standard deviations of
The impact of informational asymmetriesreturns by a factor from 2 to 5 depending on
on portfolio decisions has been first studiedrisk aversion and conclude that these scaling
in the finance literature.33 In this literature, factors are implausibly high. Albuquerque,
domestic and foreign investors differ onBauer, and Schneider (2007) solve for inter
their (exogenously given) information setsnational equity flows when a set of home and
regarding future domestic and foreign stockforeign investors have superior information.
returns. Gehrig (1993) and Brennan and CaoThey argue that this informational hetero
(1997) develop a simple two country noisy geneity within the foreign set of investors is
rational expectations model with one stockmore important than informational hetero
per country. They assume that agents in each geneity across countries to explain interna
country receive a signal on the future per tional equity trades. In line with the data, the
formance of each stock but the signal on the model explains why (i) U.S. investors trade in
foreign asset is less precise. Hence, domesticwaves, with simultaneous buying and selling;
investors perceive the foreign stock as risk(ii) U.S. investors change their foreign equity
ier and reduce their foreign stock holdings,positions gradually; and (iii) U.S. investors
which leads to equity home bias. Moreover, increase their equity position in a country
Brennan and Cao (1997) show that less wellfollowing a raise in its stock price.
informed foreign investors respond more The finance literature described above
strongly to public signals on domestic stocks had a recent impact on more standard
conveyed by stock prices. Hence, foreigngeneral equilibrium macro models along
investors buy more of the domestic stocksthe lines of the Open Economy Financial
when the domestic market performs well. Macroeconomics approach. Hatchondo
The authors find evidence for this "return (2008) builds a single good two country
model and two assets per country with two
departures from standard models. Firstly,
33 Contrary to the standard DSGE macro models, the he assumes that only local investors receive
finance literature described here relies on some partial informative signals about local assets. This
equilibrium assumptions: stock returns characteristics (risk
and expected returns) are exogenously given and the risk informational advantage induces agents
free asset is in infinite supply. to invest in the good local asset. Secondly,

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engaging in short selling is assumed to be the currently observed fundamental values

costly. When the signal is sufficiently infor- but also international capital flows (gross
mative and short selling costs are high and net). Moreover, capital flows should
enough, agents do not sell the bad local asset help forecast future fundamentals. They find
short in order to invest more in the good some empirical support for their results.
local asset but rather reduce their holdings „ , _ „ . T r , , ...
rr ■ . i i , ..i b.f.2 Endogenous Information Acquisition
of foreign assets. This leads to equity home & J '
bias in equilibrium. Gordon and Bovenberg The early noisy rat
(1996), present a small open economy model erature when applied to
where home bias results from information folio choice relies on exo
asymmetries, which decrease the return structures. A recent
home investors get on their foreign capital extend it by allowing f
investment. In such a set up, subsidizing rnation acquisition. In
capital imports is optimal. Razin, Sadka, and information is a too
Yuen (1999) assume that domestic inves- tional variance of the
tors can observe the productivity of domes- a model of rational ina
tic firms before making their loan decisions, by Sims (2003), V
while foreign investors cannot. This results Veldkamp (2009) build a
in foreign underinvestment and domestic information advantag
oversaving. Building on a similar asymmetric ate significant home b
information set up but adding the possibil- limited capacity to proc
ity of liquidity shocks, Goldstein and Razin this model, agents are e
(2006) study the trade-off between FDI and informational advant
portfolio investment, the latter being more which lowers its percei
liquid than the former. the investor will tend to hold more of the local
Tille and van Wincoop (2009) apply the asset. However, this effect is amplified as the
noisy rational expectations framework from more of an asset the agent owns, the more
the finance literature to a standard two-coun- attractive it becomes to learn about the asset.
try/one-good DSGE model. They depart Endogenous and costly acquisition of infor
from standard open macro models by intro- mation amplifies the initial small informa
ducing information dispersion across inves- tional advantage and leads to specialization
tors. Each investor receives a private signal in local stocks. Learning turns out to amplify
on the future fundamentals (productivity) of information asymmetries instead of reducing
domestic and foreign stock, the signal on its them. In their set up, countries which are
own stock being more precise (as in Gehrig learnt about a lot by investors should have
1993 and Brennan and Cao 1997). The noise lower returns compared to the prediction
is introduced in the form of (unobserved) of a standard CAPM model, as lower uncer
stochastic transaction costs to invest abroad tainty goes hand in hand with a lower return.
which generates portfolio shifts toward or Van Nieuwerburgh and Veldkamp (2010)
away from foreign assets. This makes sure apply variations of their rational inatten
that stock prices cannot fully aggregate pri- tion model to explain investment strategies
vate signals in equilibrium. These trans- of investors, varying the specification of the
action costs generate equity home bias in preferences or of the information constraint
equilibrium but this is not the purpose of that they face. Depending on the convexity
the paper. They show that dispersed private of the objective function of investors, they
information disconnects stock prices from can rationalize concentrated or diversified

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portfolios. Mondria (2010) allows rationally holdings of foreign equities are significantly
inattentive investors to decide not only on biased toward countries that have a higher
the precision but also on the structure of share of their stock market listed on U.S.
the information they process. In equilib stock exchanges. Chan, Covrig, and Ng (2005)
rium, agents choose to learn not only about find that stock market development and
individual assets but also about linear com familiarity variables have a significant impact
bination of assets, i.e., indices. Such a learn on home bias for a sample of mutual funds
ing strategy makes sense as the structure of spanning twenty-six developed and develop
the signal the agents choose in equilibrium ing markets. They aggregate the investments
depends on their objective function. Since of these funds at the country level. Grinblatt
investors will choose to hold a somewhat and Kelohaiju (2001) emphasize the key role
diversified portfolio in equilibrium, they of distance, language, and cultural similari
choose to process information about combi ties in international asset allocation. Aviat and
nations of assets (they are interested not only Coeurdacier (2007) revisit the impact of dis
in the volatility of each asset but also in their tance on cross-border equity holdings (and
covariance). Mondria and Wu (2010) use a bank loans). They find that the impact of dis
similar framework to explain the time series tance is drastically reduced once we control
of home bias. When financial liberalization for bilateral goods trade: countries' portfolios
takes place in the developed economies in are strongly biased toward trading partners
the 1980s, investors start to be able to diver (see also Lane and Milesi-Ferretti 2008).
sify their portfolios and home bias decreases Using instrumental variables, they show that
but only gradually as investors have an initial the causality goes essentially one-way: reduc
information advantage on domestic assets. ing barriers to trade in goods enhances cross
The authors show that persistence of asset border asset holdings. However, one cannot
pay-offs and increases in information pro reject the role of goods trade in fostering
cessing capacity tends to magnify home bias. information flows across borders. Since a lot
By looking at the interaction of capital open of information on stocks come through the
ness and learning strategies, they are able to accounts of firms, it is to be expected that
reproduce the time series of home bias.34 different accounting standards would act as
information barriers. Bradshaw, Bushee, and
6.1.3 Empirical Evidence on Informational
Frictions Miller (2004) find that firms exhibiting higher
levels (changes) of U.S. GAAP conformity
A number of papers regress portfolio hold have greater levels (changes) of U.S. institu
ings or measures of home bias directly on tional ownership. This positive relation holds
factors that proxy for information asymme regardless of a firm's visibility to U.S. investors
tries. Portes and Rey (2005) show that physi (e.g., American Depositary Receipt listing,
cal distance affects international equity flows stock index membership, analyst following,
and holdings very significantly: doubling the firm size). Finally, using survey data on Italian
distance reduces cross-border equity flows investors, Guiso and Jappelli (2006) find that
by half. Coval and Moskowitz (1999) find that investors who spend more time to acquire
U.S. mutual fund managers prefer to invest in information also tend to hold less diversified
nearby firms even within a country. Ahearne, portfolios as implied by models of endoge
Griever, and Warnock (2004) find that U.S. nous information acquisition.
Most models of information asymmetries
34 For a very nice exposition of the applications of ratio though also imply that domestic investors
nal inattention to invesment choice, see Veldkamp (2011). should earn a higher return than foreign

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investors. However, the empirical evidence role of self-assessed trading competences

on this matter is mixed. Coval and Moskowitz on portfolio home bias. They show how
(1999), Hau (2001), Dvorak (2005), and home bias can emerge when investor feels
Choe, Kho, and Stulz (2005) find that domes- incompetent in understanding the benefits
tic investors do in fact earn higher returns, and the risks of investing in foreign assets,
while Grinblatt and Keloharju (2000) and However, it remains difficult to disentangle
Huang and Shiu (2006) find the opposite. empirically informational frictions linked
to distance and/or institutional differences
6.2 Behavioral Biases r , , . , , . , «r i -.»
Irom behavioral biases
Some recent papers have put forward
behavioral explanation for the equity ho
bias. Using departures from rational ex
tations and maximization of standard
Neumann-Morgenstern utility functio
used in standard macro literature, this
erature has highlighted some behavior
biases consistent with the data on int
national portfolio allocation. The seminal
paper of French and Poterba (1991) al
considers overconfidence toward loc
assets as a potential explanation: if in
tors systematically have higher expect
of relative returns for domestic equi
this difference in expected returns, w
inconsistent, can overturn any perceiv
diversification gains. In the same vein
Shiller, Kon-Ya, and Tsutsui (1991) do
ment large differences in expected retur
of Japanese and U.S. investors for the
stock markets. They find that Japan
investors tend to expect relatively highe
returns for Japanese stocks, while U.S
investors expect higher returns on U.
equity. A similar argument can be app
to estimated variances (either the stan
deviation of domestic equity is systemat
cally believed to be lower or correlatio
with foreign equities are overestimate
Studies by Gur Huberman (2001), Bena
(2001), and Karlsson and Norden (2007
(see also Barberis and Thaler 2003 for a s
vey) suggest that "familiarity" might be
main determinant of portfolio choice: inv
tors choose "familiar" assets while ignori
the principles of portfolio theory. Graha
Harvey, and Huang (2009) investigate t

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7. New Portfolio Facts In figure 3, we show the evolution of bond

home bias measures in developed countries
7.1 Aggregate Data on Portfolio Holdings across regions of the world: it has decreased
over the last twenty years with the process
The Open Economy Financial Macro of "financial globalization" but remains still
economics models have implications for very high in all countries. Portfolios exhibit
international bond holdings as well as inter a home bias in bond holdings of a slightly
national equity holdings. Hence, we provide larger magnitude than the one documented
some measure of the extent of risk-sharing for equity in section 2. On average, the
through international bonds holdings (pub degree of home bias across the world is 0.75
lic and private) for a large cross section of (just like for equities it is lower in Europe
countries by using data on cross-border bond where monetary union seemed to have had
holdings. For completeness we also present an effect but higher in other countries),36
some data on international bank lending, as meaning that the share of foreign bonds
we expect that the Open Economy Financial in investors portfolios is roughly a quarter
Macroeconomics will soon incorporate for of what investors would hold if they were
mally bank intermediation in their models. holding the world bond market portfolio.
For these data, we rely on CPIS and IFS Despite a large degree of home bias, these
data from the IMF and the data from the data indicates that some international risk
BIS (see appendix for a detailed descriptionsharing occurs through bond holdings and it
of the data). seems necessary to incorporate cross-border
bond holdings in the theoretical portfolios
7.1.1 Cross-Border Bond Holdings
model we are using. In figure 4, we show
We use data from IFS and BIS to compute the degree of bond home bias for emerging
international bond holdings for selectedmarkets: emerging markets have even much
countries. Unfortunately, available data do less diversified bond portfolios than devel
not allow to disaggregate data of foreignoped countries and it has barely decreased
bond holdings across types of bonds (corpoover the last decade. Like for equities, there
rate versus public, across maturities, acrossis a significant dispersion of bond home bias
currency denomination)35 and we had toacross countries (and across time) that could
focus on bond holdings aggregates. be helpful to guide future theoretical work.
To measure the degree of international7.1.2 Cross-Border Bank Loans
diversification of bond portfolios, we com
pute a measure of home bias in bond hold We use data from the BIS and the OECD
ings similar to the one we computed forto compute cross-border banking assets for
equity holdings. Hence, our measure of selected countries. Like for bonds, available
Bond Home Bias for country i (BHB¡) isdata do not allow to disaggregate data of for
defined as follows: eign bank loans across types of loans and we
had to focus on aggregate foreign asset hold
(43) BHB; = 1 ings by banks.
To measure the degree of international di
Share of Foreign Bonds in Country i Bond Holdings
Share of Foreign Bonds in the World Bond Market Portfolio
versification of banks' portfolios, we compute
35 For more details on the currency denomination of 36 See Lane (2006), Coeurdacier and Martin (2009), and
Fidora, Fratzscher, and Thimann (2007) for studies on the
foreign assets and liabilities, see Lane and Shambaugh
(2010a, 2010b). impact of the euro on cross-border bond diversification.

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" ■— *
0.9 ^ ^ North America
U
♦—
t | Japan and Australia
0.8
World ^
0.7
Europe
0.6
0.5
05 O ,_( oq CO io CD t 00
05 O O O o o O o o
05 O O O o o o o o
CM oq oq oq oq oq oq oq oq
Figure 3. Measures of Home Bias in Bonds across Developed Countries
Note: The country measure BHB¡ is market capitalization-weighted for each region.
Sources: Authors' calculations. Bank for International Settlements and International Financial Statistics.
Countries: Japan and Australia; Europe (Austria, Belgium, Denmark, Finland, France, Germany, Iceland,
Italy, Netherlands, Norway, Spain, Sweden, Switzerland, United Kingdom); North America (Canada and
United States).
a measure of home bias in bank loans com- for a detailed description of the data),
parable to the one used for equities and Despite an increased diversification, bank
bonds. Hence, our measure of Home Bias ing portfolios still exhibit a very strong home
in Loans for country i (LHBj) is defined as bias. The magnitude of the home bias in
follows: banking assets is similar to the one observed
for equity holdings. Like for equities a
(44) LHB¡ = 1 bonds, the degree of Home Bias is the small
est in Europe (potentially due to the EMU)
Share of Foreign Banking Assets in Country i Banking Assets
and the largest in emerging markets (here
Foreign Banking Assets as a share of Total Foreign Outstanding Loans
Latin America).
In figure 5, we show the evolution of home _ ~ . ... Ir , T1 „.
, . . 7.2 Institutional Investors Home Bias Data
bias m bank loans measures across O LC D
countries using OECD data. Figure 6 shows An increasing share of capital

the same statistic but using BIS statistics intermediated through institutio
(available for a larger number of countries tors. For example, using the S
but over a shorter time period; see appendix Consumer Finance, Polkovniche

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0.95
0.85
0.75
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Figure 4. Measures of Home Bias in Bonds
Note: The country measure BHB, is market capitali

Sources: Authors' calculations. Bank for International Settlements and International Financial Statistics.
Countries: Developed (Japan, Australia, Austria, Belgium Denmark, Finland, France, Germany, Greece,
Iceland, Italy, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom, Canada and
United States); Central and South America (Argentina, Brazil, Chile, Colombia, Mexico, Peru); South Africa;
Central and Eastern Europe (Croatia, Czech Republic, Hungary, Poland, Slovak Republic); Emerging Asia
(India, Indonesia, Korea, Malaysia, Philippines, Singapore, Thailand, Turkey).
documents that, in 2001, 62 percent of all investment comes an agency problem and
equity holdings by U.S. households were the incentives of the final investor and of
indirect holdings. Information asymmetries the fund manager are not necessarily well
explanations of the home bias seem more aligned. It should therefore be informative
plausible for households than for fund man- to look at portfolio allocations at the fund
agers, who can devote a substantial amount level to understand better the determinants
of resources to gather relevant information. of home bias. Hau and Rey (2008) provides
Also, if home bias can be explained by the some descriptive statistics on domestic and
degree of sophistication of investors regard- foreign holdings of mutual funds in foul
ing their investment strategies, one would countries. We use the same data set—data
expect that professional investors would of global equity holdings from Thomson
be fully aware of the theoretical benefits of Financial Securities (TFS)—to estimate
diversification. Furthermore, with delegated home bias at the fund level on a larger cross

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102 Jou rnal of Economic Literature, Vol. LI (March 2013)
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Figure 5. Measures of Home Bias in Banking Assets acro
Note: In each region, the country measure LHB¡ is weighted by the

in the region.
Sources: Authors' calculations. Bank Profitability: Financial Statements of Banks (OECD). Countries: Japan
and Australia; Europe (Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy,
Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom); North America
(Canada and United States).
section of countries. The data document reporting dates for which holding data is
available, security price on the reporting date
individual mutual funds holdings at the stock
level. TFS was created by the merger of Theand the security price on the closest previous
Investext Group, Security Data Company days in case the reporting date had no price
and CDA/Spectrum. The data cover the information on the security, total return index
five-year period 1997 to 2002 and has(including
an dividend reinvestments) in local
currency, and daily dollar exchange rates
interesting cross-sectional and time series
dimension.3' The TFS holding data comprise for all investment destinations. Most funds
fund number, fund name, management com report only with a frequency of six months.
pany name, country code of the fund incor Reporting dates differ somewhat, but more
poration, stock identifier, country code of than
the 90 percent of the reporting occurs in
the last thirty days of each half-year. A limi
stock, stock position (number of stocks held),
tation of the data is that they do not include
any information on cash holdings, financial
37Chan, Covrig, and Ng (2005) used a similar dataset—
albeit only for one year. They aggregate the data
leverage,
across all
investments in fixed income instru
funds to document home bias at the country level. ments or investments in derivative contracts.

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TABLE 3
Market Capitalization (Average for 1997:1 to 2002:2)—Bn Dollars
United States Germany United Kingdom Canada Switzerland F ranee
2,851 225.8 174.6 84.81 74.18 53.43
Sweden Hong Kong Italy Spain Netherlands Belgium

43.84 26.22 26.03 21.52 12.88 12.55
Japan Singapore Luxembourg Ireland South Africa Norway

11.96 9.052 6.35 6.215 3.076 2.559
TABLE 4
Number of Funds (Average for 1997:1 to 2002:2)
United States Germany United Kingdom Canada Switzerland France

3,165 1,223 495 353 140 212
Sweden Hong Kong Italy Spain Netherlands Belgium
168 66 74 231 66 101
Japan Singapore Luxembourg Ireland South Africa Norway

48 47 54 26 35 34
The portfolio c
therefore conc
tion of a funds
breakdown of t
ization over the
by country of f
breakdown of t
also by count
Figure 7 prese
funds based in
of domestic hol
0 percent, stric
smaller than 10
percent, . . . ,
(but strictly be
100 percent. T
the 1997-2002
these different
in total holding
bias." For each

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2001 2002 2003 2004 2005 2006 2007 2008
Figure 6. Measures of Home Bias
Note: In each region, the country measu

in the region.
Sources: Authors' calculations. Bank fo

Denmark, Finland, France, Germany,
Sweden); North America (Canada and
Mexico); World (Belgium, Denmark,
Netherlands, Portugal, Spain, Sweden
Panama, Turkey).
the distribution lying in between

extremes, indicating a great deal
geneity in diversification choices
managers even within country.
conjecture is that the observed
pattern at the fund level reflect
increasing returns in the inform
nology leading to some concentra
holdings of either domestic or fo
tries and a particular market stru
ing product differentiation at th
As mentioned in Hau and Rey (
is a positive correlation betwee
of sectors and the number of cou

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United States United Kingdom
0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100 0 0-10 10-20 20-30 30-40 40-50 .50-60 60-70 70-80 80-90 90-100 100
Home-bias degree Home-bias degree
Canada Germany
■ Home bias by fund v
I Home bias by number
0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100 0 0-10 10-20 20-30 30-40 40-50 .50-60 60-70 70-80 80-90 90-100 100
Sweden France
0.45
0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 1(X) 0 0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100
Figure 7. Home Bias is Measured by Shares of Domestic H

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Spain Switzerland
0-10 10-20 20-30 30-40 40-50 .50-60 60-70 70-80 80-90 90-100 100 0 °"10 10-2° 2°-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100
Belgium Luxembourg
■ Home bias by fund value
■ Home bias by number of fun
0 0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100 0 0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100
Italy Japan
0.70 .
I Home bias by fund value o 0.60 I Home bias by fund value

I Home bias by number of funds I Home bias by number of funds
0 0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100 0 °-10 10-2° 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100
Figure 7. Home Bias is Measured by Shares of Domestic Holdings in T

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Hong Kong Singapore
I Home bias by fund value I Home bias by fund value

I Home bias by number of funds I Home bias by number of
0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100 0 0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100
Netherlands South Africa
I Home bias by fund value

I Home bias by number of funds
0 0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100 0 0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100
Norway Ireland
I Home bias by fun

I Home bias by num
0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100 0 0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100 100
Figure 7. Home Bias is Measured by Shares of Domestic Holding

210.12.45.98 on Tue, 05 Apr 2022 02:31:57 UTC
exogenous. They too result from the opti- or fiscal rules will be the way to go. It is an
mizing behavior of financial companies. important goal to have realistic and work
Explaining home bias or indeed investment able macroeconomic models of the open
strategies at the fund level thus probably economy with endogenous portfolio choice,
requires a theory of fund mandates. as large cross border holdings of assets (see
Gourinchas and Rey 2007a) are likely to
o ^ , . i t j r affect the channels of transmission of mon
8. Conclusions and Leads tor , , r. , TT , . i- ,i
„ . „ i etary and fiscal policy. Understanding the
buture Research , 1 , F Í , , °
short run dynamics
Our view is that the home bias puz
is now less of a puzzle. From the lit
ture we labeled "Open Economy Fin
Macroeconomics" to the rational ina
models featuring endogenous inform
acquisition, notable progress has been
to understand the determinants of
lio allocations. We may now be at a
where we should be studying a broad
of implications of these new models ra
than focusing only on the stylized fac
equity home bias. Confronting their p
tions with a large set of other stylized
portfolio holdings will surely lead us
them further and ultimately assess the
explanatory power. States may be challenged by the new portfo
The Open Economy Financial Macro- lio diversification strategies of emerging mar
economics literature has an interesting set of kets in general and China in particular. We
predictions on the holdings of a broad menu have few models that can tackle these issues
of financial assets. It should be very fruitful in a general equilibrium set up with a rich
to introduce in that literature some more asset structure. The role of international cur
detailed models of the capital structure of rencies and their importance in determining
firms and to get finer empirical implications portfolios and asset price movements is an
for equities and corporate/banking debt in area of active research (see Devereux and
particular. Applying corporate finance theory Shi 2009 or Gourinchas, Rey, and Govillot
to model the capital structure of firms seems 2010).
a natural extension of these models, all the As more detailed survey data on house
more so since it has been shown to matter holds become available, one will also be bet
empirically to explain the home bias (see ter able to test at the microeconomic level
Dahlquist et al. 2003). One major issue going the empirical relevance of various hedging
forward will also be the modeling of the offi- motives underlying the mechanism of these
cial sector. Introducing an optimal monetary Open Economy Financial Macroeconomic
or fiscal policy and modeling their interac- models. Estimating the correlation of labor
tions with endogenous portfolio choices of income risk with various asset returns at a
the private sector is a major challenge. It is disaggregated level—for instance according
likely that as a first step focusing on realistic to levels of wealth—would probably enhance
but not necessarily optimal monetary policy our understanding of the plausibility of the

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CoeurcLacier and Rey: Home Bias in Open Economy Financial Macroeconomics 109
mechanisms. Importantly, introducing mod- (35 percent of families), direct holdings

els with heterogeneous agents in an interna- of pooled investment funds (21 percent of
tional economics set up seems a priority to families), and managed investment accounts
understand better some of the most stub- (8 percent of families). If we take a different
born puzzles of international economics angle and look at the total amount of equity,
such as the Consumption-Real Exchange 37.8 percent was held in tax-deferred retire
Rate anomaly (Kollmann-Rackus-Smith ment accounts, 33.6 percent as directly held
puzzle). Limited participation in asset mar- stocks, 22.1 percent as directly held pooled
kets is a promising way to help resolve some investment funds, and 6.5 percent as other
asset pricing puzzle as shown in particular in managed assets. Strikingly if we look at the
the context of a closed economy by Guvenen families holding stocks directly 36 percent
(2009). Some steps have been taken by of them hold only one stock and 48 percent
Kollmann (2012) and by Coeurdacier, hold between two and nine stocks. The typi
Ocaktan, and Rey (2010) in particular to cal portfolio of households who participate
introduce limited participation in an open in the financial market is therefore very
economy set up. Furthermore, much like the dichotomic: it contains a very small num
closed economy macroeconomics literature, ber of stocks, which are directly held and
the modeling of financial intermediaries is a more diversified stock portfolio, which is
a key missing building block in our current usually managed by a third party. It is still
DSGE models of the open economy. As the a major challenge for the existing literature
literature stands, we have nothing interest- to reproduce such a dual investment strat
ing to say about leveraged intermediaries for egy at the household level. It is even more
example and their role in the international of a challenge to reproduce it together with
transmission of shocks. the great heterogeneity in investment strate
If we want to take a more detailed micro- gies at the fund level that we documented in
economic view of the home bias, we have graph 1. The endogenous information acqui
to recognize the large heterogeneity of sition literature (see Van Nieuwerburgh and
investment strategies both at the household Veldkamp 2010) seems promising since in
level and at the fund manager level. A large the presence of increasing returns to infor
share of household investment is not direct mation acquisition, it is possible to generate
portfolio holdings but intermediated. In concentrated portfolios, a prediction that
the United States, according to the Survey accords well with the directly held portion
of Consumer Finance (see Polkovnichenko of household equities. It should however
2005), the share of equity held indirectly by probably be enriched with a model making
households through mutual funds, pension explicit delegated portfolio management
funds or other investment vehicles has risen strategies. A first step in this direction has
from about 46 percent in 1989 to close to been taken by Dziuda and Mondria (2012).
62 percent in 2001. The Federal Reserve In their paper, asymmetrically informed
Bulletin (2009) indicates that between 2004 households delegate their investment deci
and 2007, the fraction of families holding sions to fund managers of stochastic abili
publicly traded stocks rose to 51.1 percent. ties. Since domestic households know more
Among families that held equity, either about home country assets, they are better
directly or indirectly, in 2007, ownership able to evaluate the performance of manag
through a tax-deferred retirement account ers investing in home assets. Hence more
was most common (84 percent of fami- highly skilled managers, who benefit from
lies), followed by direct holdings of stocks transparency, are more likely to operate in

210.12.45.98 on Tue, 05 Apr 2022 02:31:57 UTC
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Home Bias in Open Economy Financial Macroeconomics

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Home Bias in Open Economy

Nicolas Coeurdacier and Hélène Rey*

Home bias is a perennial feature of international capital markets. We review various

1. Introduction fully mobile across borders. Because foreign

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2. The Equity Home Bias:

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Figure 1. Home Bias in Equities Mea

Note: The country measure EHB, is market

Sources: Authors' calculations. International

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Home Bias in Equities in 2008 for Selected Countries

Domestic market in % Share of portfolio in Degree of equity home bias

China 7.8 99.2 0.99

Canada 2.7 80.2 0.80

Euro Area 13.5 56.7 0.50

Japan 8.9 73.5 0.71

South Korea 1.4 88.5 0.88

Sweden 0.7 43.6 0.43

Switzerland 2.3 50.9 0.50

United Kingdom 5.1 54.5 0.52

equity home bias in multicountry models of financial economists and macroeconomists

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2001 2002 2003 2004 2005 2006 2007 2008

Figure 2. Home Bias in Equities M

Note: The country measure EHB¡ is marke

Sources: Authors' calculations. Internation

equity could help to smooth cons

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how recent methodological developments in dynamics of the model only depends on

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adequate in environments where standard • Nontradable income risk: investors

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endogenous capital accumulation in the sub Technologies and Firms' Decisions

(3) Ci t = [oV+iclJ*-1** where wit is the country i wage rate.

with j f i, (7) di t — ap¡ t yi t.

where cj t is country is consumption of the Financial Markets and Instantaneous

where pit is the price of good i. (8) PUCU +pltS'it+1 +p?,tSjtt+l

= wi,tkt + (du + pit)S[t

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Equation (9) represents the optimal alloca- r ,. . ,. r,

(12) Sjj +sf,:l = SÇj + Sj, = 1. (13) _ = = )

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Using intratemporal first-order condition (17) (PHjCHj-PFjCFj)

(15) yt = where wtlt = wHtlHt — wFtlFt denotes

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(iv) a decrease in the returns on Home 4.2.1 Hedging with Bond an

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24 See Coeurdacier, Kollmann, and Martin (2010)

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Finns' Decisions the Home (Foreign) good in all future peri

(28) Pit Cit + pi j SiJ+l + pjj Sji(+i