Working Paper: NBER ID: w14734
Authors: Pierpaolo Benigno; Salvatore Nistic
Abstract: This paper proposes an explanation of the international home bias in equity based on ambiguity aversion. Doubts imply an additional hedging motif driven by the interaction between real exchange rate risk and ambiguity aversion. What matters is the long-run as opposed to the short-run risk. Domestic equity is a good hedge with respect to long-run real exchange rate risk even when bonds are traded. The higher is the degree of ambiguity aversion, the stronger is the home bias. We identify the degree of ambiguity aversion with detection error probabilities and show that our framework is able to explain a large share of the observed US home bias, as well as other stylized facts on US cross-border asset holdings. \n\nWithout doubts, a standard open-economy macroeconomic model would be unsuccessful along all these dimensions.
Keywords: Home Bias; Ambiguity Aversion; International Finance; Portfolio Allocation
JEL Codes: F3; G11; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| ambiguity aversion (D81) | home bias (F23) |
| ambiguity aversion (D81) | domestic asset holdings (F21) |
| ambiguity aversion (D81) | foreign asset holdings (G15) |
| real exchange rate risk (F31) | ambiguity aversion (D81) |
| ambiguity aversion (D81) | portfolio choices (G11) |