Di¤erences of Opinion and International Equity Markets

We develop an international nancial market model in which domestic and foreign residents di¤er in their beliefs about the information content in public signals. We determine how informational advantages by domestic investors in the interpretation of home public signals impact equity markets. We evaluate the ability of our model to generate four international nance anomalies: (i) the co-movement of returns and capital ows; (ii) home-equity preference; (iii) the dependence of rm returns on home and foreign factors; and (iv) abnormal returns around foreign rm crosslisting in the home market. Their relationships with empirical di¤erences-of-opinion proxies are consistent with the model. For valuable suggestions, we thank Geert Bekaert, Urban Jermann, Leonid Kogan, Stavros Panageas, Anna Pavlova, Raman Uppal, Frank Warnock, Wei Xiong, and three anonymous referees. We are also grateful for comments from participants at presentations given at Wharton School, HEC Lausanne, the CEPR Fourth Annual Workshop on Global Interdependence at the European University Institute, 8th Annual Swiss Doctoral Workshop in Finance at Gerzensee, the NBER meeting of International Finance and Macroeconomics, Princeton University, Carnegie Mellon University, the Adam Smith Asset Pricing Conference at the Oxford-Man Institute, the American Finance Association annual meeting, the 10th Annual Darden International Finance Conference, the Sixth Biennial McGill Global Asset Management Conference, the Society for Economic Dynamics annual meeting, Cornell University, University of Southern California, University of Houston, University of Calgary, University of Texas at Dallas, Rutgers University, and the Federal Reserve Board. We thank Frank Warnock and Stephanie Curcuru for advice with reconstructing the US net equity purchases data, Ivan Shaliastovich for the forecast variance data, and Xiang Fang for excellent research assistance. Dumas and Osambela gratefully acknowledge the nancial support from NCCR FINRISK of the Swiss National Science Foundation. Dumas is also grateful for the hospitality of Collegio Carlo Alberto, and for the support from: the INSEAD research fund, BI Norwegian Business School, and the AXA Chair in Socioeconomic Risks at the University of Torino. Lewis acknowledges funding from the National Science Foundation and the Wharton-SMU Research Center with thanks. yINSEAD, University of Torino, NBER and CEPR. E-mail: bernard.dumas@insead.edu zThe Wharton School of the University of Pennsylvania and NBER. E-mail: lewisk@wharton.upenn. edu xTepper School of Business, Carnegie Mellon University. E-mail: osambela@cmu.edu In almost all models of economic theory, behavioral di¤erences among consumers are attributed to di¤erences in preferences or in the information they possess. In real life, di¤erences in consumer behavior are often attributed to varying intelligence and ability to process information. Agents reading the same morning newspapers with the same stock price lists will interpret the information di¤erently.  Ariel Rubinstein (1993) cited by Kandel and Pearson (1995). How do di¤erences in interpreting the same information a¤ect nancial markets? This question is at the core of a growing Di¤erence-of-Opinion (hereafter DOO) literature. While di¤ering opinions may exist between agents in any market, international markets provide a natural place to study their e¤ects. Evidence of nancial market segmentation across countries has been documented extensively, with di¤erent perceptions across those countries often cited as a source. Perhaps people of di¤erent countries harbor di¤erent opinions that a¤ect their ability to process information relevant to the analysis of economies other than their own. As such, the international nancial market may be viewed as a natural laboratory for analyzing the e¤ects of di¤ering opinions. In this paper, therefore, we propose a fully dynamic DOO model based upon international differences in perceptions about economic information, incorporating the equilibrium consumption of utility-maximizing investors. We assume that home investors are better at understanding home signals, and, as such, are rational about home information. However, investor groups in both countries misinterpret the information about the other countrys prospective growth and are, therefore, equally rational or irrational. We call this new feature foreign sentiment.  The information assumption captures the idea that, while foreigners may see home information as well as home residents do, they do not know how to interpret it. The assumption may be motivated (in an unmodeled way) in at least three di¤erent ways, all stemming from the hypothesis that investors start history with priors that ignore the relationships (i.e., correlations) between the signals and the growth rates, and gradually discover them as data comes in. First, it could be that home investors have had a longer time to study the relationship. From this perspective, it may be taking foreigners a longer time to learn how to interpret the home signal and, if so, our model is analyzing a long