A Global Equilibrium Asset Pricing Model with Home Preference

Abstract

International audienceWe develop a global equilibrium asset pricing model assuming that investors suffer from foreign aversion, a preference for home assets based on familiarity. Using a utility formulation inspired by regret theory, we derive closed-form solutions. When the degree of foreign aversion is high in a given country, investors place a high valuation on domestic equity, which results in a low expected return. Thus, the model generates the simple prediction that a country's degree of home bias and the expected return of its domestic assets should be inversely related. Our predicted relation between the degree of home bias and a country's expected return has the opposite sign predicted by models that assume some form of market segmentation. Using International Monetary Fund portfolio data, we find that expected returns are negatively related to home bias

Stock market integration, cost of equity capital, and corporate investment: Evidence from Brazil

“…A strong reason why market segmentation exists is because investor behavioral biases affect asset allocations (Solnik & Zuo, ). Despite diversification benefits, investors exhibit a home bias, investing disproportionally more in domestic stocks.…”

International Market Integration: A Survey

“…The international asset pricing literature also considers models with other sources of risk, such as exchange rate risk (Adler and Dumas, 1983; Chaieb and Errunza, 2007; De Santis and Gerard, 1998; Dumas and Solnik, 1995), consumption risk (Colacito and Croce, 2013; Lewis and Liu, 2015; Sarkissian, 2003; Wheatley, 1988), restricted assets (Errunza and Ta, 2015; Solnik and Zuo, 2011), liquidity risk (Bekaert et al ., 2007a; Goyenko and Sarkissian, 2014; Karolyi et al ., 2012; Lee, 2011), and information flow Dumas et al , 2017; Van Nieuwerburgh and Veldkamp, 2009). Another strand of literature explores factor models, such as the world APT and world multi‐beta models (Bekaert et al , 2009; Ferson and Harvey, 1993; Fama and French, 2012; Hou et al , 2011).…”

Equity Home Bias: A Review Essay

“…Investors use the domestic portfolio as the benchmark portfolio and feel the pain of regret when their foreign investments underperform, and consequently the model results in equity home bias. Furthermore, Solnik and Zuo () note that in a given country, when the degree of foreign aversion is high, domestic investors place a high valuation on domestic stocks, which in turn results in a low expected return. Thus, a country's degree of equity home bias and the expected rate of return on its domestic stock are inversely related.…”