Human Capital and Imperfectly Informed Financial Markets
6 Pages Posted: 24 Aug 2010
Date Written: August 20, 2010
Deviating from conventional models in financial economics which maintain that markets are perfectly informed, more recent work has relied on the role of private information to explain observed portfolio choices or their impact on market outcomes in financial and currency markets (see, e.g., Philippe Bacchetta and Eric Van Wincoop 2006, and Stijin Van Nieuwerburgh and Laura Veldkamp 2009). These studies have not offered, however, a testable model of endogenous information acquisition. Following Isaac Ehrlich, William A. Hamlen Jr., and Yong Yin (2008), we here pursue such a model, based on the role of human capital in information production, and test its power to explain variations in “home bias” - the holding of home, relative to foreign, stocks - across international markets.
There is an extensive literature in financial economics that offers various explanations for “home bias.” What we add to these studies is the role of prior knowledge and private information acquisition in imperfectly informed markets. Our model of endogenous information acquisition, or “asset management” (cf. Ehrlich and Uri Ben-Zion 1976), relies on heterogeneity in individuals’ human capital endowments - both “general” and “specific” - to explain evidence on diversity in home bias at both the micro and macro levels in a multi-asset framework. Our model predicts that while a conditional increase in general human capital, proxied by schooling, increases the expected absolute demand for both home and foreign stocks, “home bias” at the market level is an inverted-U function of schooling. This prediction is confirmed in our empirical investigation.
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