International Macroeconomics With Imperfect Financial Markets

A review of recent advances in open economy analysis under segmented international financial markets. A set of modeling tools that have been used to understand ?financialcrises, the ensuing policy response (e.g., Quantitative Easing and FX intervention), deviations from arbitrage (CIP deviations), and more generally the impact of capital flows on exchange rates. This modeling approach has also sheds a different light onclassic topics such as the exchange rate disconnect, international risk sharing, UIPfailures, and the carry trade.

Home Bias in International Macroeconomics

Home bias in international macroeconomics refers to the fact that investors around the world tend to allocate majority of their portfolios into domestic assets, despite the potential benefits to be had from international diversification. This phenomenon has been occurring across countries, over time, and across equity or bond portfolios. The bias towards domestic assets tends to be larger in developing countries relative to developed economies, with Europe characterized by the lowest equity home bias, while Central and South America—by the highest equity home bias. In addition, despite the secular decline in the level of equity home bias over time in all countries and regions, home bias still remains a robust feature of the data. Whether home bias is a puzzle depends on the portfolio allocation that one uses as a theoretical benchmark. For instance, home bias in equity portfolio is a puzzle when assessed through the lens of a simple international capital asset pricing model (CAPM) with homogeneous investors. This model predicts that investors should hold world market portfolios, namely a portfolio with the share of domestic asset equal to the share of those assets in the world market portfolio. For instance, since the share of US equity in the world capitalization in 2016 was 56%, then US investors should allocate 56% of their equity portfolio into local assets, while investing the remaining 44% into foreign equities. Instead, foreign equity comprised just 23% of US equity portfolio in 2016, hence the equity home bias. Alternative portfolio benchmark comes from the theories that emphasize costs for trading assets in international financial markets. These include transaction and information costs, differential tax treatments, and more broadly, differences in institutional environments. This research, however, has so far been unable to reach a consensus on the explanatory power of such costs. Yet another theory argues that equity home bias can arise due to the hedging properties of local equity. In particular, local equity can provide insurance from real exchange rate risk and non-tradable income risk (such as labor income risk), and thus a preference towards home equities is not a puzzle, but rather an optimal response to such risks. These theories, main advances and results in the macroeconomic literature on home bias are discussed in this article. It starts by presenting some empirical facts on the extent and dynamics of equity home bias in developed and developing countries. It is then shown how home bias can arise as an equilibrium outcome of the hedging demand in the model with real exchange rate and non-tradable labor income risk. Since solving models with portfolio choice is challenging, the recent advances in solving such models are also outlined in this article. Integrating the portfolio dynamics into models that can generate realistic asset price and exchange rate dynamics remains a fruitful avenue for future research. A discussion of additional open questions in this research agenda and suggestions for further readings are also provided.

The determinants of home bias

Despite the well-known gains of the international diversification, investors have the tendency to overinvest in domestic equities. This irrational behavior is called home bias. It is considered by Obstfeld and Rogoff (2000) as one of the six major puzzles in the international macroeconomics. The present paper examines the different determinants to understand this major puzzle. Based on a sample of 564 observations (countries-years) that cover the period 2003 to 2013, we found that home bias is explained by the information asymmetry that exists between countries and their economic volatility (assessed by the growth rate of the gross domestic product). Furthermore, our findings indicate that home bias decreases among developed markets and countries characterized by a higher rule of law.