Portfolio Home Bias and External Habit Formation

Speaker: Andreas Stathopoulos, USC Marshall

Organized by: Department of Finance

Abstract: There is currently a consensus in the international finance literature that hedging against real exchange rate risk is unable to account for the empirically observed level of equity home bias. As a result, the literature has largely focused on friction-based explanations. This paper aims to challenge that consensus by proposing a novel mechanism that is able to generate significant equity home bias in the absence of any frictions in the markets for goods and assets. I consider a multi-country general equilibrium model which features cross-country heterogeneity in conditional risk aversion, generated by the interaction of home bias in preferences and external habit formation. In equilibrium, each country’s consumption share is increasing in its conditional risk aversion and decreasing in all other countries’ conditional risk aversion, so financing equilibrium consumption entails hedging against increases in home conditional risk aversion. If preferences are sufficiently home biased, an increase in home risk aversion leads to a relative appreciation of the home equity. As a result, home equity is a better hedge against home risk aversion than foreign equity, inducing portfolio home bias. Furthermore, the presence of external habit formation allows the model to generate realistic asset price dynamics, satisfying a long-standing need of the international asset pricing literature.