410 critical review:
The world price of home bias
Cost of capital refers to cost of equity capital.
Control for traditional risk proxies, country-specific characteristics and availability of market substitutions.
Measure home bias by looking at how domestic mutual funds in different countries allocate their equity portfolios between domestic and foreign stocks.
Analysis would be more accurate if they were based on individual and institutional investors, however mutual funds are a popular vehicle for investing.
Advances on existing literature:
They perform direct tests of home-bias effects on the cost of capital of a country and the tests allow them to quantify the magnitude of the costs of capital impact of home bias.
Proxies for cost of capital (p3):
ICOC (computed using earnings forecasts) – has been widely adopted in the accounting literature shown that ICOC is able to explain the international risk-return relationship. 2nd – average realised return and 3rd – the expected dividend yield. The latter proxies do not require accounting information and are commonly applied in finance literature. By employing 3 different types of cost of capital proxies it ensures that the home-bias effect is not sensitive to a particular cost of capital proxy.
Problems with other literature:
Previous studies were looking at the effects of events showing that stock market liberalisation increases stock returns through a decrease in the cost of capital. They tend to overstate the costs of capital benefits of market liberalisation and assume that firms experience a constant growth before and after the stock market liberalisation. Studies using Tobin’s q rations face the endogeneity problem when examining the valuation impact of foreign ownership, using the cost of capital approach evades this problem. Their approach provides a direct test of the cost of capital impact of home bias and gauge the size of the impact. This study also examines the cost of capital impact of home bias at the country and firm levels across a broad range of countries compared to other studies which focused on a subset of countries that had experienced stock market liberalisation.
Global risk sharing is limited by various investment constraints faced by both foreign and local investors.
The equations imply that investors with concentrated domestic asset holdings would need to be compensated with higher returns, as there is less global risk sharing between domestic and foreign investors. Thus higher level of bias leads to higher cost of capital.
Data and sample construction:
Thomson Reuters’ database only includes equity mutual funds that hold at least on stock. Therefore it excludes money market and fixed income funds.
Brazil, Taiwan and Thailand invest all their wealth in local equity markets, even though their respective world-market capitalization weights are about 0.71%, 1.1% and 0.23% respectively.
Performed that same analysis as in Hail and Leuz (2006) by using the...