Equity Home Bias When Firms are Indebted

Abstract

Generally, labor earnings depend on the financial leverage of firms. We account for this to revisit the classical and debated argument according to which equity home bias is the consequence of investors seeking to insure against idiosyncratic changes in their labor income. In an otherwise standard international macro model with portfolio choice, leverage has real effects on the labor market and households' risk sharing motives through the credit spread. Driven by two types of technology shocks and financial shocks, this model suggests that leverage reduces the appetite for domestic equities. This result is consistent with the negative correlation between the change in equity home bias and that in the credit to non-financial corporations found in advanced economies’ data for the period 1980 through 2018.

Keywords: risk sharing, country portfolios, contract enforcement, working capital, leverage

JEL Classification: E2, F4, G11, G15