Working Paper: CEPR ID: DP6902
Authors: Nicolas Coeurdacier; Robert Kollmann; Philippe Martin
Abstract: Despite the liberalization of capital flows among OECD countries, equity home bias remains sizable. We depart from the two familiar explanations of equity home bias: transaction costs that impede international diversification, and terms of trade responses to supply shocks that provide risk sharing, so that there is little incentive to hold diversified portfolios. We show that the interaction of the following ingredients generates a realistic equity home bias: capital accumulation, shocks to the efficiency of physical investment, as well as international trade in stocks and bonds. In our model, domestic stocks are used to hedge fluctuations in local wage income. Terms of trade risk is hedged using bonds denominated in local goods and in foreign goods. In contrast to related models, the low level of international diversification does not depend on strongly countercyclical terms of trade. The model also reproduces the cyclical dynamics of foreign asset positions and of international capital flows.
Keywords: capital accumulation; capital flows; current account; international equity and bond portfolios; terms of trade; valuation effects
JEL Codes: F2; F3; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| capital accumulation shocks (E22) | equity home bias (G12) |
| investment efficiency shocks (G14) | equity home bias (G12) |
| international trade dynamics (F10) | equity home bias (G12) |
| investment efficiency shocks (G14) | net foreign asset positions (F32) |
| investment efficiency shocks (G14) | international capital flows (F32) |
| fluctuations in investment (E22) | home dividends (G51) |
| fluctuations in investment (E22) | labor incomes relative to foreign counterparts (F16) |
| equity home bias (G12) | local labor income volatility (J69) |
| net foreign asset changes (F32) | asset price fluctuations (G19) |