International Financial Management 2nd Edition by Geert Bekaert ,Robert Hodrick

Exercise 17

Economists continue to be puzzled by the apparent home bias of investors across countries. With mean-variance preferences, investors ought to allocate much more of their wealth to foreign equities and bonds. Three explanations for the phenomenon are given below, all of them based on empirical facts. For each one, discuss whether the statements are true or false and in what sense they help, or fail, to rationalize the home bias puzzle. In answering the questions, assume that investors have meanvariance preferences.
a. Investors should not hold foreign equities because they are more volatile and have been yielding lower returns than U.S. stocks in recent years.
b. Home bias arises because investors face an additional risk when investing internationally- namely, currency risk. Because currency risk makes returns more volatile but does not lead to a higher expected return, investing more in domestic assets is rational.
c. Home bias arises because investors have a non-traded domestic asset that they care about as well-namely human capital. The returns to this asset can be thought of as labor income. It has been empirically determined that labor income correlates quite highly with U.S. stock returns.