Non-fundamental Home Bias in International Equity Markets

TL;DR

This paper explores how behavioral unfamiliarity and return correlations influence the equity home bias, revealing that unfamiliarity increases bias while return correlation decreases it, with additional insights on excess returns and investor risk aversion.

Contribution

It provides empirical evidence linking country-specific unfamiliarity and return correlations to the equity home bias, using a novel proxy and robust statistical methods.

Findings

Country-specific unfamiliarity positively correlates with home bias.

Return correlation negatively correlates with home bias.

Excess home return positively influences home bias under certain risk preferences.

Abstract

This study investigates the relationship of the equity home bias with 1) the country-level behavioral unfamiliarity, and 2) the home-foreign return correlation. We set the hypotheses that 1) unfamiliarity about foreign equities plays a role in the portfolio set up and 2) the correlation of return on home and foreign equities affects the equity home bias when there is a lack of information about foreign equities. For the empirical analysis, the proportion of respondents to the question "How much do you trust? - People you meet for the first time" is used as a proxy measure for country-specific unfamiliarity. Based on the eleven developed countries for which such data are available, we implement a feasible generalized linear squares (FGLS) method. Empirical results suggest that country-specific unfamiliarity has a significant and positive correlation with the equity home bias. When it comes to the correlation of return between home and foreign equities, we identify that there is a negative correlation with the equity home bias, which is against our hypothesis. Moreover, an excess return on home equities compared to foreign ones is found to have a positive correlation with the equity home bias, which is consistent with the comparative statics only if foreign investors have a sufficiently higher risk aversion than domestic investors. We check the robustness of our empirical analysis by fitting alternative specifications and use a log-transformed measure of the equity home bias, resulting in consistent results with ones with the original measure.