Do Trade Barriers Affect the Equity Home Bias ?

Abstract

In this paper, we show that the effect of trade barriers on the equity home bias can vary depending on economic environments. Even though there have been a variety of studies related to the relation between trade barriers and the equity home bias since Obstfeld and Rogoff (2000), reliable empirical research has never been conducted on this topic. In order to examine this issue with econometric model, we measure the equity home bias both in US and European Union with a more improved method. Based on this measurement, we discuss the interesting characteristics of the equity home bias which are not consistent with the existing viewpoints and employ a VAR model for further empirical analysis. Through the analysis, we find that the impact of trade barriers on the equity home bias varies depending on each economy.

1. Introduction

Since the seminar paper of French and Poterba(1991), the "equity home bias" has been an interesting issue among financial and macro economists. The equity home bias means that investors possess domestic equities(or assets) far more than the optimal levels suggested by financial theories. Assuming that most investors are rational enough to hedge their risks by investing in sufficiently diversified assets, there is no reason for them to possess domestic assets excessively.

Admittedly, there exist many studies which focus on explaining the equity home bias through a variety of approaches. For instance, Ahearne, Griever, and Warnock (2000), Portes and Rey (2005) and Daude (2006) suggest that asymmetric information can explain a large amount of the equity home bias. Some other studies including Burger and Warnock (2004) and Wei(2005) point out the role of domestic institutions or policies. Finally, others emphasize the importance of local preference inclined to domestic assets. However, these are not directly related to the intention of this paper.

In 2000, Obstfeld and Rogoff published ‘The six major puzzles in international macroeconomics : Is there a common cause?' and this paper is the starting point of our discussion. In the paper, the authors suggested that ‘trade barriers' may be a common cause of the six major puzzles in international macroeconomics including the equity home bias. According to their argument, a static two-country general equilibrium model with complete markets and trade barriers can describe the equity home bias in the real world fairly well. Even though the argument itself seemed quite neat and logical, many researchers, especially financial economists, refuted Obstfeld and Rogoff (2000) saying that the model was too simple. However, it is also true that there have not been enough evidence to deny or accept Obstfeld and Rogoff (2000) in that a general equilibrium model without dynamics cannot be examined numerically. Also, most researchers assume that the influence of trade barriers on the equity home bias is homogeneous across countries. This, however, is not a desirable approach since the relation between trade barriers and the equity home bias can be affected by a variety of factors.