TY - JOUR AU - Wincoop,Eric van AU - Warnock,Francis E. TI - Is Home Bias in Assets Related to Home Bias in Goods? JF - National Bureau of Economic Research Working Paper Series VL - No. 12728 PY - 2006 Y2 - December 2006 UR - http://www.nber.org/papers/w12728 L1 - http://www.nber.org/papers/w12728.pdf N1 - Author contact info: Eric van Wincoop Department of Economics University of Virginia P.O. Box 400182 Charlottesville, VA 22904-4182 Tel: 434/924-3997 Fax: 434/982-2904 E-Mail: vanwincoop@virginia.edu Francis E. Warnock Darden Business School University of Virginia Charlottesville, VA 22906-6550 Tel: 434/924-6076 Fax: 434/243-8945 E-Mail: warnockf@darden.virginia.edu AB - 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. ER -