Do Trade Costs in Goods Market Lead to Home Bias in Equities?

Abstract

Two of the main puzzles in international economics are the consumption and the portfolio home biases. We solve for international equity portfolios in a two-country/two-good stochastic equilibrium model with trade costs in goods markets. We show that introducing trade costs, as suggested by Obstfeld and Rogoff (2000), is not sufficient to explain these two puzzles simultaneously. On the contrary, we find that trade costs create a foreign bias in portfolios for reasonable parameter values. This result is robust to the addition of non-tradable goods for standard calibrations of the preferences.

Keywords: Home Bias, Portfolio Choice, Trade Costs

JEL Classification: F30, F36, F41