Home bias in equity portfolios, inflation hedging, and international capital market equilibrium

We test whether the home bias in equity portfolios is causedby investors trying to hedge inflation risk. The empirical evidenceis consistent with this motive only if investors have very highlevels of risk tolerance and equity returns are negatively correlatedwith domestic inflation. We then develop a model of internationalportfolio choice and equity market equilibrium that integratesinflation risk and deadweight costs. Using this model we estimatethe levels of costs required to generate the observed home biasin portfolios consistent with different levels of risk aversion.For a level of risk aversion consistent with standard estimatesof the domestic equity market risk premium these costs are abouta few percent per annum greater than observable costs such aswithholding taxes. Thus, the home bias cannot be explained byeither inflation hedging or direct observable costs of internationalinvestment unless investors have very low levels of risk aversion.     

The role of information asymmetries and inflation hedging in international equity portfolios

We investigate the role of information asymmetries and inflation hedging in shaping international equity portfolios. We confirm, in a multinational setting, Cooper and Kaplanis [Cooper, I.A., Kaplanis, E., 1994. Home bias in equity portfolios, inflation hedging and international capital market equilibrium. Review of Financial Studies 7 (1), 45–60] result of no inflation hedging motive driving investors’ behavior and find evidence of a crucial role for financial market development and trade linkages.     

Immigration and equity home bias

Why do investors hold such large positions in domestic equity when there are gains to be made from international diversification? This equity home bias puzzle has received considerable attention in the literature, with asymmetric information on domestic and foreign assets (whether by individual choice or by market imperfection) emerging as the most plausible explanation. What happens when we consider a subset of investors whose information sets are closer to investors in foreign countries? I assess the relationship between immigration and equity home bias and find that inward migration is positively correlated with increased foreign equity positions and reduced home bias. Looking across income groups, outward migration reduces home bias for relatively rich countries, but may actually increase home bias when migration occurs to or from a developing country. These results suggest that immigration generates a positive externality of increased information flows for developed countries, but not for developing nations. The effects of immigration on investment are strongest within the Euro-Zone, suggesting that this positive externality of immigration is largest when barriers to portfolio diversification (such as currency risk) are lowest.     

Familiarity bias and earnings-based equity valuation

Review of Quantitative Finance and Accounting - This study examines whether investors’ familiarity bias affects their earnings-based equity valuation. Building on theoretical and empirical...     

The size of venture capital and private equity fund portfolios

We propose a model that examines the optimal size of venture capital and private equity fund portfolios. The relationship between a VC and entrepreneurs is characterized by double-sided moral hazard, which causes the VC to trade off larger portfolios against lower values of portfolio companies. We analyze the structural relations between the VC's optimal portfolio structure and entrepreneurs' and VC's productivities, their disutilities of effort, the value of a successful project, and the required initial investment in a venture. We also test the model's predictions using a small proprietary dataset collected through a survey targeted to VC and private equity funds worldwide.     

International equity flows and country funds

This study investigates the relationships between U.S. equity flows in foreign countries and returns of closed-end country funds for emerging Latin American markets, emerging Asian markets and developed markets. The major issues addressed are (1) relationships between flows and fund returns based on two basic models—information contribution and feedback trading effects, (2) the role of volatility in these relationships, and (3) the effects of the Asian crisis. Basic findings include: (1) information contribution (past flows affect returns) and feedback trading arguments (past returns affect flows) are supported; (2) strong evidence is found for the market segmentation argument rather than the investor sentiment argument; (3) there exists strong evidence of significant volatility effects under information contribution and feedback trading; (4) the Asian crisis effects are important but limited to Asian funds.     

Country-specific equity market characteristics and foreign equity portfolio allocation

Do country-specific equity market characteristics explain variations in foreign equity portfolio allocation? We study this question using comprehensive foreign equity portfolio holdings data and different measures of country-specific equity market factors for 36 host countries. Employing panel data econometric estimations, our investigation shows that foreign investors prefer to invest more in larger and highly visible developed markets which are more liquid, exhibit a higher degree of market efficiency and have lower trading costs. The findings imply that by improving the preconditions necessary for well-functioning capital markets, policymakers should be able to attract higher levels of foreign equity portfolio investments.     

Optimizing international portfolios with options and forwards

We develop a stochastic programming model to address in a unified manner a number of interrelated decisions in international portfolio management: optimal portfolio diversification and mitigation of market and currency risks. The goal is to control the portfolio’s total risk exposure and attain an effective balance between risk and expected return. By incorporating options and forward contracts in the portfolio optimization model we are able to numerically assess the performance of alternative tactics for mitigating exposure to the primary risks. We find that control of market risk with options has more significant impact on portfolio performance than currency hedging. We demonstrate through extensive empirical tests that incremental benefits, in terms of reducing risk and generating profits, are gained when both the market and currency risks are jointly controlled through appropriate means.     

Behavioral currency hedging for international portfolios

The purpose of this paper is to incorporate behavioral issues as it relates to the active currency hedging of international portfolios in the context of traditional expected utility maximization approach. The uniqueness of the approach is that separate risk aversion parameters are introduced for asset and currency markets. The paper is similar in spirit to Black (Black, F. 1989, Universal hedging, Financial Analysts Journal (July-August), 16-22.), who argued that a portion of foreign equity investments should be permanently unhedged, which is basically postulating that one should take a buy-and-hold position in currency with a fraction of the capital. The behavioral twist included in the traditional expected utility maximization approach results in lower hedge ratios, ceteris paribus, partly due to the asymmetric nature of the compensation structure of currency managers.Since the asymmetric nature of incentive schemes of asset and currency managers dictates how one optimizes the investment portfolio of a pension or endowment fund, the unusual behavior of a given institutional fund manager should not be called “irrational,” only because the optimal currency hedging level deviates from the one derived under rational expectations. This only justifies the use of different hedging strategies by various institutional investors. We describe in detail how the level of hedging should be revised downwards because of behavioral factors. Conclusions are in the context of what people would predict to see in the market, if certain investors behave in an “irrational” way.     

Volume and skewness in international equity markets

We examine the relation between trading volume and skewness in 11 international stock markets using daily and monthly data from January 1980 to August 2004. We construct single equation and VAR models of the relation between the first three moments of market returns and trading volumes. Our results show hitherto unrecognised channels of influence, and support the investor heterogeneity approach to explaining return asymmetries.     

Active currency management of international bond portfolios

This paper focuses on the estimation and implementation of a holistic quantitative yield-curve-based approach to managing multi-currency bond portfolios. The primary task of the presented model is to manage the portfolio risk and return by exploiting inefficiencies in the emergent complexity of both currency and bond markets to generate alpha. Instead of using proxy variables, the expected return and risk parameters are estimated directly using their underlying simplicity and connectivity, period by period at specific moments in time, thus generating time diversification with aggressive risk taking and positioning. As a result, the strategies described in this paper can be classified as both alpha hunters and generators.     

Measures of equity home bias puzzle

The paper develops measures of home bias for 42 countries over the period 2001 to 2011 by employing various models: international capital asset pricing model (ICAPM), classical mean-variance, minimum-variance, Bayes–Stein, Bayesian, and multi-prior correction to Bayesian. ICAPM country portfolio weights are computed relative to world market capitalization. Bayesian model allows for various degrees of mis-trust in the ICAPM and multi-prior model's investors' ambiguity aversion. Mean-variance computes optimal weights by sample estimates of mean and covariance matrix of sample return and Bayes–Stein improves precision associated with estimating the expected return of each asset. The paper finds that, for few countries, there is not much change in home bias measures using various models. Foreign listing, idiosyncratic risk, beta, natural resources rents, size, global financial crisis and institutional quality have significant impact on home bias. There are policy implications associated with home bias.     

Risk sharing,finance, and institutions in international portfolios

We develop a standard model to show how transaction costs in international investment affect conventional tests of consumption risk sharing, both in a multilateral and a bilateral setting. We implement the tests in a novel international data set on bilateral holdings of equity, bonds, foreign direct investment (FDI) and bank loans. In our data, high foreign capital holdings are associated with international consumption risk sharing as implied by our theory. This is especially true of investment in equity or bonds, but not of foreign direct investment or bank loans. In our model, the implication is that transaction costs are higher for FDI and international loans. The discrepancy could reflect technological differences, but also the prospect of expropriation, perhaps most stringent for FDI or loans. We argue that expropriation risk is endogenous to both the borrower's institutions and its openness to international markets. The detrimental impact of poor institutions is muted in open economies, where the possibility of subsequent exclusion from world markets deters expropriation of foreign capital. We show the implied effects of institutions prevail in both the cross-section of consumption risk sharing and in observed international investment patterns.     

The selection of multinational equity portfolios: forecasting models and estimation risk

The problem considered is the selection of a portfolio of international assets, particularly the forecasting of the inputs to a selection algorithm. Four models of the asset return generating process are considered, two of which ignore the international nature of the universe of assets, two which exploit it in different ways. Several estimation methods are considered for each component: expected return, variance and covariance of returns. The combinations of model and estimation method are first evaluated in terms of their forecasting performance for the components mentioned for the individual assets. The universe used is the components of the Financial Times Eurotrack 100 Index. Significant differences were found between the forecasting accuracy of the methods considered for each component. In the final stage of the analysis, a comparison of the returns on portfolios chosen using each combination showed a significant difference. The analysis suggests that the choice of estimation method is more critical than the choice of pricing model.     

Risk premia in international equity markets revisited

Recent evidence suggests that global equity markets are becoming more risky. We develop a model to explain risk premia in international equity markets. The model is then used to investigate the changing nature of conditional risk premia and their effect on unconditional global risk. Using this model we find that the increase in international variance and covariance of realized excess returns can be attributed to systematic variations in global risk premia correlated across markets as well. Understanding this additional source of increased global correlation is important. These results have interest both for practitioners and for those interested in modeling global asset prices.     

Global private information in international equity markets

This paper studies international equity markets when some investors have private information that is valuable for trading in many countries simultaneously. We use a dynamic model of equity trading to show that global private information helps explain US investors’ trading behavior and performance. In particular, the model predicts global return chasing (positive co-movement of US investors’ net purchases with returns in many countries) which we show to be present in the data. Return chasing in our model can be due to superior performance of US investors, not inferior knowledge or naive trend-following. We also show that trades due to private information are strongly correlated across countries. A common (global) factor accounts for about half their variation.     

Disclosure and the cost of equity in international cross-listing

In this paper, we examine the relationship between disclosure level and the cost of equity capital for a sample of international firms cross-listing on the New York Stock Exchange. Increased disclosure has the potential to reduce information asymmetry, reduce the cost of financing and increase analyst following. Using an international asset pricing model, we find that listing firms experience a decrease in both disclosure risk and systematic risk while matching firms do not. Further, we find that the magnitude of the decrease is related to three types of disclosure: accounting standards; analyst following; and exchange/regulatory investor protection. Our results suggest that increased disclosure through accounting standards is beneficial to investors and that disclosure can be accomplished through information intermediaries, e.g., analyst following. For firms with the lowest levels of disclosure prior to cross-listing, all three types of disclosure appear to be valuable.

Decomposing the persistence of international equity flows

The portfolio flows of institutional investors are widely known to be persistent. What is less well-known, however, is the source of this persistence. One possibility is the ‘informed trading hypothesis:’ that persistence arises from autocorrelated trades of individual investors who believe they have information about value and who face an imperfectly liquid market. Another possibility is that there are asynchroneities with respect to investment decisions across funds, across investments, or both. These asynchroneities could be due to wealth effects (across investments for a single fund), investor herding (across funds for a single investment), or generalized contagion (across funds and across investments). We use daily data on institutional flows into 21 developed countries by 471 funds to measure and decompose aggregate flow persistence. We find that the informed trading hypothesis explains about 75% of total persistence, and that the remaining amount is attributable entirely to cross-fund own-country persistence. While asynchroneities across funds investing in the same country are important, asynchroneities across countries, either within a given fund, or across funds, are not important. The cross-fund flow lags we identify might result from different fund investment processes, or from some funds mimicking others' decisions. We reject the hypothesis that wealth effects explain persistence.     

Suboptimal international equity portfolio diversification and stock market development

Review of Quantitative Finance and Accounting - This paper examines whether the widely reported phenomena of home and foreign biases (i.e. suboptimal international equity portfolio diversification)...     

Dependence structure and extreme comovements in international equity and bond markets

Common negative extreme variations in returns are prevalent in international equity markets. This has been widely documented with statistical tools such as exceedance correlation, extreme value theory, and Gaussian bivariate GARCH or regime-switching models. We point to limits of these tools to characterize extreme dependence and propose an alternative regime-switching copula model that includes one normal regime in which dependence is symmetric and a second regime characterized by asymmetric dependence. We apply this model to international equity and bond markets, to allow for inter-market movements. Empirically, we find that dependence between international assets of the same type is strong in both regimes, especially in the asymmetric one, but weak between equities and bonds, even in the same country.