Hedging against the government: a solution to the home asset bias puzzle

By Tiago C. Berriel and Saroj Bhattarai

http://d.repec.org/n?u=RePEc:fip:feddgw:113&r=dge

This paper explains two puzzling facts: international nominal bonds and equity portfolios are biased domestically. In our two-country model, holding domestic government nominal debt provides a hedge against shocks to bond returns and the impact on taxes they induce. For this result, only two features are essential: some nominal risk and taxes falling only on domestic agents. A third feature explains why agents choose to hold primarily domestic equity: government spending falls on domestic goods. Then, an increase in government spending raises the returns on domestic equity, providing a hedge against the subsequent increase in taxes. These conclusions are robust to a wide range of preference parameter values and the incompleteness of financial markets. A calibrated version of the model predicts asset holdings that quantitatively match the data.

An interesting take of the portfolio home bias: it is the result of hedging against fiscal policy. But given that government expenses are procyclical in some countries and countercyclical in others, I wonder whether this can really be generalized beyond the United States, which the model economy is calibrated for.

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