This paper proposes an explanation of the international home bias in equity based on ambiguity aversion. We develop a simple dynamic model of consumption and portfolio decisions and derive the optimal portfolio allocation in terms of covariances between excess returns and the implied sources of risk. Under rational expectations and log utility, the only relevant risk underlying portfolio choices arises from fluctuations in non-tradeable labor income. We find that this hedging motif is empirically too weak to explain the observed lack of international diversification in equity portfolios. On the other hand, in an economy populated by ambiguity-averse agents, model uncertainty becomes an additional hedging reason which translates into long-run real exchange rate risk and is relevant even under log utility. We calibrate the degree of ambiguity aversion using detection error probabilities, and show that our framework is able to explain a large share of the observed U.S. home bias, as well as other stylized facts on U.S. cross-border asset holdings.
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This paper was revised on May 20, 2009
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