A Rational Explanation for Home Country Bias

41 Pages Posted: 11 Nov 2008

See all articles by Iftekhar Hasan

Iftekhar Hasan

Fordham University - Gabelli School of Business; Bank of Finland

Yusif Simaan

Fordham University - Gabelli School of Business

Date Written: 1999

Abstract

While modern portfolio theory predicts that investors should diversify across international markets, corporate equity is essentially held by domestic investors. French and Poterba (1991) suggest that in order for this bias to be justified, investors must hold optimistic expectations about their domestic markets and pessimistic expectations about their foreign markets. Tesar and Werner (1995) find existing explanations to the home equity bias unsatisfactory and conclude that the issue poses a challenge for portfolio theory. We develop a model that incorporates both the foregone gains from diversification and the informational constraints of international investing, and shows that home equity bias is consistent with rational mean-variance portfolio choice. Specifically, we prove that the nature of estimation risk in international markets can be responsible for this phenomenon. We show that when the cross-market variability in the estimation errors of international markets' means far exceeds the cross-market variability in the means themselves, domestic dedication dominates international diversification. An examination of eleven international markets' returns over the last twenty-five years, from the perspective of German, Japanese and U.S investors provides evidence consistent with this explanation.

Suggested Citation

Hasan, Iftekhar and Simaan, Yusif, A Rational Explanation for Home Country Bias (1999). NYU Working Paper No. FIN-99-067. Available at SSRN: https://ssrn.com/abstract=1298851

Iftekhar Hasan

Fordham University - Gabelli School of Business ( email )

Rose Hill Campus Bronx
New York, NY 10458
United States

Bank of Finland ( email )

P.O. Box 160
Helsinki 00101
Finland

Yusif Simaan

Fordham University - Gabelli School of Business ( email )

113 West 60th Street
Dept. of Finance
New York, NY 10023
United States
212-636-6116 (Phone)

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