Working Paper: NBER ID: w17560
Authors: Nicolas Coeurdacier; Pierre-Olivier Gourinchas
Abstract: This paper presents a model of international portfolios with real exchange rate and non financial risks that accounts for observed levels of equity home bias. A key feature is that investors can trade equities as well as domestic and foreign real bonds. Bonds matter: in equilibrium, investors structure their bond portfolio to hedge real exchange rate risk since relative bond returns are strongly correlated with real exchange rate movements. Equity home bias does not arise from the co-movements between relative stock returns and real exchange rates, but from the hedging properties of stock returns against other sources of risk, conditionally on bond returns. We estimate the optimal equity and bond portfolios implied by the model for G-7 countries and find strong empirical support for the theory. We are able to account for a significant share of the equity home bias and obtain a currency exposure of bond portfolios comparable to the data.
Keywords: Home Bias; International Portfolios; Real Exchange Rate Risk; Bond Holdings
JEL Codes: F30; F41; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| bond returns (G12) | real exchange rate fluctuations (F31) |
| real exchange rate fluctuations (F31) | bond returns (G12) |
| equity returns (G12) | non-financial income risk (G19) |
| bond holdings (G12) | equity home bias (G12) |
| equity home bias (G12) | optimal portfolio allocations (G11) |
| bond returns (G12) | optimal equity positions (G12) |