(Asymmetric) Trade Costs, Real Exchange Rate Hedging, and Equity Home Bias in a Multi-Country Model

Abstract

There has been controversy between (two-country) theory and the empirics about whether hedging against real exchange rate fluctuations in the goods market influences foreign equity holdings. This study reconciles the theory with the empirics by introducing a multi-country framework with asymmetric trade costs. We find that the incentive to hold foreign equities to hedge real exchange rate risk is negligible because multiple trade partners act as a hedging channel for real exchange rate fluctuations. Further, our theory calls for a country’s covariance-variance ratio to be constructed as the sum of the bilateral covariance-variance ratios of the multiple partners. The empirical analysis of 24 advanced countries confirms the theoretical prediction.

Keywords: Multi-country model, International portfolio allocation, Real exchange rate hedging, Equity home bias, Trade costs, Non-tradable goods

JEL Classification: F30, F36, F41, G11