Determinants of Home Bias Puzzle in European Countries

(ProQuest: . denotes formula omitted.)IntroductionInternational diversification responds to the well-known adage: Don't Put All Your Eggs in One Basket. The goal of any rational investor is to find the optimal combination of financial assets in his portfolio, which provides the best performance for a certain level of risk. Assets and portfolios are therefore identified by their couples (average return, risk) where risk is measured by the expected variance. After the pioneering work of Markovitz (1952, 1959) on portfolio optimization, and extensions to the international context by Grubel (1968), Levy & Sarnat (1970), and Lessard (1973), many studies in finance have examined the effects of international diversification in portfolios. Not surprisingly, since portfolio diversification depends on the correlations between return distributions of assets, which tend to be lower between- than within-countries, the gains from global portfolio diversification have been found to be large.Despite its potential gains and the easier access to financial markets worldwide (Baele and Inghelbrecht, 2009; Chiou, 2009), international portfolio diversification has not been as fully embraced as expected. The actual portfolios that investors hold are heavily weighted in favor of domestic assets and international diversification gains have not been widely exploited by investors due to the so-called "home bias". This phenomenon reflects investors' preference for domestic equity and reluctance to diversifying.Excellent literature reviews on home bias up to the year 2000 can be found in Lewis (1999) and Karolyi and Stulz (2003). In this paper, we cover only the recent findings on international portfolio choice. Studies that try to resolve the equity home bias puzzle focus on institutional explanations or individual investor behavior.We propose in this study to contribute to this body of research by analyzing some determinants of the home bias and investigating the impact of the European integration since the introduction of the unique currency (Euro) has removed investment barriers and eliminated exchange rate among European member states.Numerous studies have so far quantified the extent of the home bias for investors in various countries but the contribution of this paper is to study the evolution of this bias among a period of twelve years from 2001 to 2012 and specially the effect of the 2008 crisis. We propose also to examine the effect of the number of industries in each country, the effect of European Monetary Union and the impact of the 2008 financial crisis on home bias. To our knowledge no previous study, has taken on consideration the impact of this variables to explain investor's preference for national assets.The paper is organized as follows: The next section reviews the theoretical framework proposed by several studies trying to explain home bias. In Section 2 we study the evolution of home bias over time.The third section introduces the methodology and the data set. The fourth section discusses the results of the estimations. The last section concludesSection 1: BackgroundLiterature on the reasons as to why investors prefer domestic assets in their portfolio mainly fall into different explanations and several authors have focused on this phenomenon as French and Poterba (1991), Cooper and Kaplanis (1994), Tesar and Werner (1995), Baxter and Jermann (1997), Kho et al. (2009), Arouri (2008); De Santis and Gerard (2009); Coeurdacier and Guibaud(2011). ). The explanations offered are very different, even contradictory. Among the institutional explanations, a number of attempts have addressed the issue in terms of direct barriers to international investments such as capital controls (Errunza and Losq, 1985; Stulz, 1981; Black, 1974) or other forms of market imperfections such as transaction costs (Rowland (1999), Warnock (2001)). However, most of these explanatory factors are rejected with the acceleration of financial globalization of capital markets starting from the mid-1980 and the relatively higher volumes of cross-border trading as revealed by high turnover rates in international transactions rule out these explanations (Warnock, 2002; Tesar and Werner, 1995). …