Is Home Bias in Assets Related to Home Bias in Goods?

Eric van Wincoop, Francis E. Warnock

NBER Working Paper No. 12728
Issued in December 2006
NBER Program(s):   IFM

Obstfeld and Rogoff (2000) have reinvigorated an old literature on the link between home bias in the goods market and home bias in the asset market by arguing that trade costs in the goods market can account for the observed portfolio home bias. The key link between home bias in the two markets is the real exchange rate. Home bias in consumption implies a different expenditure allocation across countries, which leads to different inflation rates when measured in the same currency. This leads investors from different countries to choose different portfolios to hedge against inflation uncertainty. An older partial equilibrium literature argued that such hedge portfolios are not large enough to produce substantial home bias. We link the general equilibrium and partial equilibrium literatures and show that in both the resulting home bias in the equity market depends on a covariance-variance ratio: the covariance between the real exchange rate and the excess return on home relative to foreign equity, divided by the variance of the excess return. Empirical evidence shows that this ratio and the implied home bias are close to zero, casting significant doubt on a meaningful link between home bias in the goods and asset markets. General equilibrium models that conclude otherwise imply a covariance-variance ratio that is at odds with the data.

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Document Object Identifier (DOI): 10.3386/w12728

Published: van Wincoop, E., and F. Warnock, "Can trade costs in goods explain home bias in assets?" Journal of International Money and Finance. Volume 29, Issue 6, October 2010, Pages 1108-1123

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