Hélène Rey | Macro Paper Warehouse

Home Bias in Open Economy Financial Macroeconomics

This is a survey of the “home bias” puzzle: the well-documented fact that investors everywhere hold a disproportionate share of their wealth in domestic equities, bonds and bank assets, well beyond what standard portfolio theory recommends. Coeurdacier and Rey organize the literature into three broad classes of explanation – hedging motives in frictionless financial markets, asset trade costs, and informational frictions and behavioral biases – and give particular attention to a “new” macroeconomics literature they label Open Economy Financial Macroeconomics, which embeds non-trivial international portfolio choice into standard two-country DSGE models. Using such a model with both bonds and equities, they show that once real-exchange-rate risk is hedged through bond positions, the remaining equity position optimally hedges human-capital risk conditional on bond payoffs – a channel that, unlike the unconditional hedge used in earlier equity-only models, robustly generates home bias in both the model and in the authors’ own new cross-country evidence. The survey also reviews the transaction-cost literature (concluding that plausible costs are generally too small to explain observed home bias, except when diversification gains are themselves small), the literature on informational asymmetries and endogenous information acquisition, and behavioral explanations built on differences in investor beliefs. It closes by presenting new descriptive evidence on cross-border bond holdings, bank lending and institutional (mutual fund) holdings, and by arguing that “the home bias puzzle is now less of a puzzle” than it once was, while flagging major open areas – modeling the official sector, financial intermediaries, delegated investment and heterogeneous investors – for future work.

The determinants of cross-border equity flows

Very little was established about what determines international trade in securities, partly for want of data. This paper assembles a panel of annual bilateral gross cross-border portfolio equity transactions – purchases plus sales – among 14 countries from 1989 to 1996, 1456 observations in all, whose distinguishing feature is that it records country pairs that exclude the United States, so the US’s special status as the largest economy, a leading financial centre and the issuer of the main international currency can be controlled for rather than assumed away. Deriving the estimating equation from a micro-founded model of asset trade with imperfectly substitutable assets, transaction and information costs, and endogenous asset supply, the authors regress log transactions on the two countries’ equity market capitalisations, an index of financial-market sophistication, and distance. The elasticities on market capitalisation are close to and never statistically distinguishable from the theoretical value of one; adding distance gives a coefficient of -0.881 with a standard error of 0.031 and raises the R-squared from 0.555 to 0.693, so that “with five independent variables, this straightforward, simple ‘gravity’ regression captures almost 70% of the variance,” and 84 percent in a between-estimator cross-section. That distance matters so much is the puzzle the paper is built around, since “unlike goods, assets are ‘weightless’, and distance cannot proxy transportation costs,” and a diversification motive would give distance a positive sign because business-cycle correlations fall with distance. The authors’ answer is that distance inversely proxies information, which they test with variables that represent information more directly: bilateral telephone call traffic (normalised by country size, and exogenous to financial activity by construction), the number of branches in the destination country of banks headquartered in the source country, trading-hours overlap, and a survey index of insider trading in the destination market. Telephone traffic and bank branches are consistently significant with the expected positive signs and reduce but do not eliminate the distance coefficient; insider trading is the least stable, insignificant in the full panel but correctly signed and significant (-0.398, standard error 0.117) within Europe, where perceived insider trading varies far more. Six explanatory variables capture 45 percent of the variance of bilateral flows and 65 percent of the cross-sectional variance. The results survive a long list of robustness checks – full source- and destination-country dummy sets, adjacency and common-language dummies, regional and currency-bloc dummies, financial-centre dummies, dropping the US and then the UK (distance elasticities of -0.721 and -0.856), restricting to intra-European flows (-0.727) or excluding them (-0.632), year-by-year and country-by-country estimation, instrumenting market capitalisation, and controlling for bilateral goods trade (distance falls to -0.529 but stays strongly significant). On diversification the paper is deliberately cautious: the return-covariance term enters positively (0.346, standard error 0.136) when the information variables are omitted, takes its theoretically predicted negative sign only once distance and the information variables are included, and the authors conclude there is “weak evidence for a diversification motive for asset trade in our annual data, but only when we control for the informational friction,” explicitly less robust than the information results. Two extensions widen the claim. Running the same information variables through a matched panel of manufactures trade cuts the goods-trade distance elasticity from -0.547 to -0.279, suggesting distance proxies information in the goods gravity equation too. And on a separate US-centred dataset built from the 1994 and 1997 Treasury benchmark surveys, the elasticity of US transactions with respect to US holdings is 1.05 (standard error 0.053, R-squared 0.87) and a holdings regression reproduces a distance elasticity of -0.71 – results the authors call “illustrative” given only 80 observations. The paper’s summary verdict is that “[i]nternational capital markets are not frictionless: they are segmented by informational asymmetries or familiarity effects,” a claim about segmentation rather than about the welfare cost of it.

U.S. Monetary Policy and the Global Financial Cycle

A single global factor extracted from a large panel of risky asset prices traded around the world falls sharply after a US monetary contraction, alongside deleveraging by global banks, a rise in aggregate risk aversion, contracting credit provision and retrenching international credit flows – and countries with floating exchange rates are subject to financial spillovers of similar magnitude. The paper proceeds in two empirical steps plus a model. First, a dynamic factor model fitted to 858 monthly price series for 1990-2012 – equities from North America, Latin America, Europe, Asia Pacific and Australia, corporate bond indices, and commodities excluding precious metals – supports a unique common global factor that accounts for over 20 percent of the common variation; on a narrower 303-series panel covering only the US, Europe, Japan and commodities but reaching back to 1975, one factor accounts for about 60 percent. Second, monthly Bayesian VARs with 12 lags estimated over 1980-2010 – a 13-variable closed-economy version and 15-variable global versions – are identified with an external instrument built from 30-minute price revisions in the fourth federal funds futures contract around FOMC announcements. For a shock normalised to raise the one-year Treasury rate by 1 percent on impact, the domestic responses are conventional: production, capacity utilisation and housing starts fall, unemployment rises, prices decline without a price puzzle, the excess bond premium and mortgage spreads widen, house prices and the S&P 500 fall, and the dollar appreciates. The global responses are the paper’s point. The global factor drops about 40 percent on impact, which the authors translate – under the explicit assumption that all asset prices load equally on the factor – into roughly an 8 percent fall in a local stock market, a figure consistent with the estimated US, UK and euro-area equity responses. Measured aggregate risk aversion rises by over 50 percent above its average trend. Global domestic credit and cross-border credit inflows to both banks and non-banks contract by several percentage points, with global real activity outside the US left unchanged on impact as a control, and the credit contraction is not driven by the US component. Leverage falls strongly and quickly for US security brokers and dealers and for European global systemically important banks, while broader banking aggregates react later and more weakly – no appreciable change for US banks and a European trough about a year out. Restricting the global aggregates to the 32 countries the IMF classified as independently floating leaves the credit and inflow contractions “very similar to that obtained over the full sample.” For the UK and euro area specifically, equity indices plummet, the dollar appreciates in a reversal-prone way over one to four quarters, corporate spreads widen on impact, and policy rates ease endogenously by about 30 basis points – so the local tightening of financial conditions “cannot be ascribed to a domestic monetary policy tightening.” The authors state the interpretive limit carefully: the floater result “challenges the degree of monetary policy sovereignty of open economies” and echoes Rey’s (2013) trilemma-to-dilemma claim, but “does not mean that exchange rate regimes do not matter,” and whether open-economy models with Value-at-Risk-type frictions can actually reproduce these regularities “still remains to be seen.”