A Rational Explanation For Home Country Bias
1999
Iftekhar Hasan and Yusif Simaan
ABSTRACT
While modern portfolio theory predicts that investors should diversify across international markets, corporate
equity is essentially held by domestic investors. French and Poterba (1991) suggest that in order for this bias
to be justified, investors must hold optimistic expectations about their domestic markets and pessimistic expectations
about their foreign markets. Tesar and Werner (1995) find existing explanations to the home equity bias unsatisfactory
and conclude that the issue poses a challenge for portfolio theory. We develop a model that incorporates both the
foregone gains from diversification and the informational constraints of international investing, and shows that
home equity bias is consistent with rational mean-variance portfolio choice. Specifically, we prove that the nature
of estimation risk in international markets can be responsible for this phenomenon. We show that when the cross-market
variability in the estimation errors of international markets' means far exceeds the cross-market variability in
the means themselves, domestic dedication dominates international diversification. An examination of eleven international
markets' returns over the last twenty-five years, from the perspective of German, Japanese and U.S investors provides
evidence consistent with this explanation.
Hasan: (212) 998-0329 ihasan@stern.nyu.edu
Simaan: (212) 678 0757 simaan@ibm.net
To download a copy of this paper click here
To request a copy of this paper click here
The Finance Department Working Paper Series has been generously sponsored by