External Habit Formation and the Home Bias Puzzle
47 Pages Posted: 30 Oct 2002
Date Written: November 2002
Abstract
The equity home bias, the observed lack of international diversification in equity portfolios, is a persistent puzzle in international finance. We propose an explanation for this puzzle based on external habit formation preferences. Agents' utility depends on the difference between consumption and a slow-moving subsistence level. The subsistence level, or external habit, is a backward-looking moving average of national aggregate consumption. We assume that a small group of agents holds primarily domestic securities. We can think of these agents as small business owners who are forced to hold domestic assets for agency reasons. If the remaining agents have external habit formation utility, then they will mimic the domestic bias of this small group.
We perform a calibration using consumption and asset return moments from several countries and show that this effect can potentially explain a large aggregate holding of domestic assets. The model performs especially well in explaining high equity home bias in small countries, where the observed lack of international diversification is most puzzling.
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