A Global Equilibrium Asset Pricing Model with Home Preference
Hong Kong University of Science & Technology (HKUST) - Department of Finance
Cornell University - Samuel Curtis Johnson Graduate School of Management
March 5, 2011
We develop a global equilibrium asset pricing model assuming that investors suffer from foreign aversion, a preference for home assets based on familiarity. Using a utility formulation inspired by regret theory, we derive closed-form solutions. When the degree of foreign aversion is high in a given country, investors place a high valuation on domestic equity, which results in a lower expected return. Thus, the model generates the simple prediction that a country’s degree of home bias and the expected return of its domestic assets should be inversely related. Our predicted relation between the degree of home bias and a country’s expected return has the opposite sign predicted by models that assume some form of market segmentation. Using IMF portfolio data we find that expected returns are negatively related to home bias.
Number of Pages in PDF File: 38
Keywords: International Asset Pricing, Home Bias, Familiarity, Regret
JEL Classification: G12, G15
Date posted: March 6, 2011 ; Last revised: November 8, 2011
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