Portfolio Valuation in the Presence of Market Frictions

I. INTRODUCTION Modern portfolio theory suggests that the international diversification does better than portfolio diversification in the national level. The benefits from international diversification have been emphasized over the past forty years by several authors including Solnik (1974a) and De Santise and Bruno (1997). Despite the gains from international diversification, most investors hold nearly all of their wealth in domestic assets. This is referred to in international finance as "home bias equity". Many authors tend to explain this phenomenon by market frictions such as transaction costs, taxes, restrictions on foreign ownership, asymmetric information, etc. Black (1974) presents a model of international asset pricing in the case of market segmentation. He develops a two country-model in the presence of explicit barriers to international investments in the form of a tax (on holdings of assets in one country by residents of the other country). The tax is intended to present various kinds of barriers to international investment, such as the possibility of expropriation of foreign holdings, or a transaction cost on trading assets. Black's (1974) model was extended by Stulz (1981b). In this paper, Stulz (1981b) considers the tax on the short and long positions. In these two models, the home bias equity is explained by the effect of this tax that prevents the domestic investors from investing in foreign countries. In recent studies, Cooper and Kaplanis (2000) extend Stulz's (1981 b) model to the case of n countries. They show that the deadweight cost has an impact on portfolio choice and capital budgeting decisions. Cooper and Kaplanis (1994) extend the model developed by Adler and Dumas (1983) to account for deadweight costs or taxes. The empirical test provided by Cooper and Kaplanis (1994) shows that the effect of inflation rate risk and the differences between the consumption baskets do not explain the home bias equity in international finance. In recent studies Lewis (1999) uses a similar tax as Black (1974) in order to explain the home bias equity. Errunza and Losq (1985) present a two-country-model to characterize the mild segmentation. The foreign investors called unrestricted can trade on both assets 'eligible' or restricted and 'ineligible' or unrestricted. Domestic investors trade only on the 'eligible' or unrestricted assets. The domestic investors can not participate in the foreign market due to the restriction imposed by the foreign government. Errunza and Losq (1985) show that the unrestricted assets are priced as if the international markets were integrated, and that the restricted assets are priced differently. The unrestricted investors recommend a super risk premium for the restricted assets which is proportional to the conditional market risk. Errunza and Losq (1989) show that the removal of investment barriers generally leads to an increase in the aggregate market value. The authors suggested that the introduction of different types of index funds in the international market increase the world market integration and investor welfare. Other authors consider a two-country-model in the world, one domestic and one foreign. The proportion of the number of assets held by the domestic investors is assumed to be [delta]. The authors show that price of the same foreign asset is different for the domestic and foreign investors. The difference between the price paid by the domestic and foreign for the same assets is explained by the constraint imposed on the domestic investors. These investors are willing to pay a premium over the price of foreign asset under no restriction, and the foreign investors demand a discount over the same price of the foreign under no restriction. Hietala (1989) presents a two-country-model. The domestic country has two types of assets, restricted assets which are held by the domestic investors and unrestricted assets held by the foreign and domestic investors. …