Information Asymmetry and Home Equity Bias


By

Titas Rudra
Research Scholar and Teaching Assistant
Indian Institute of Management Calcutta
(IIM Calcutta)
 


Concept of 'HOME BIAS' :

According to the traditional portfolio theory developed by Sharpe and Lintner the investors should invest in foreign securities to achieve the diversification gain. This gain exists due to the low correlation between the foreign and domestic securities. But in reality all over the world it can be seen that there is a tendency of investors to invest in domestic equities rather than foreign equities. This is what popularly known as 'HOME BIAS'.

Plausible Causes of 'HOME BIAS':

Previous researchers sited various explanations for the existence of home bias. The important ones are as follows:

  • Direct barrier Capital control is a direct barrier to foreign investment. But with more and more countries coming up with well-functioning capital market this barrier is no longer remain an important one
  • Hedging motive It is argued that home assets provide better hedges again home country specific risks.
  • Language and cultural barrier Empirical literature shows that different language and culture discourage people to invest outside.
  • Underdeveloped stock market For investment in any foreign country equity the stock market of that country has to be well-developed. Otherwise it is not possible to invest there.
  • Poor corporate governance structure Any firm should have a well structured, transparent corporate governance system so that the foreign investors can rely upon them while investing.
  • High transaction costs This barrier is no longer found much important as it is argued that the transaction costs for investing in home equities are not less than foreign equities.
  • Geographic distance Empirical studies also found distance as an important barrier.
  • Size Foreign investors are mostly institutional investors who prefer to invest in large firms than small firms.
  • Behavioral bias Recent literatures are talking more about behavioral biases like familiarity, overoptimism, patriotism, loyalty and overconfidence. It is argued that investors find these traits important before investing and hence they go for home country investment where all these traits are applicable.
  • Information asymmetry Last but not the least is the information asymmetry bias which many researchers found as the single-most important factors behind home bias. They argue and also provide evidence that since there exist information asymmetry between home country and foreign country investors, the foreign investors have to bear more information cost while investing which discourage foreign investment. In fact among the previous mentioned factors, language and cultural barrier, poor corporate governance structure, distance, size, behavioral biases etc, play as proxies for information asymmetry.  Different language between home and foreign countries leads to information asymmetry. If the corporate governance structure is poor and there is less transparency among the controlling shareholders and foreign investors information asymmetry will arise leading to home bias. It is also argued that investors can have less access of information for firms located far and smaller in size. Behavioral biases discussed earlier also exist due to asymmetric information between domestic and foreign investors. Investors feel more optimistic, confident and familiar to their domestic investment because they have informational advantage.

How to reduce 'HOME BIAS'?

As information asymmetry has been found to be one of the most important cause for the existence of home equity bias, I am considering the reduction of this factor as a weapon to reduce the home bias. Information asymmetry arises due to many factors such as different regulatory requirements, existence of local media, problems of language and communication between two countries etc. But even if there are flows of foreign capital to a country it is found that the individual firms within the country are not uniform in receiving such foreign flows. For these it can be argued that the corporate disclosure quality of the firms should be improved so that the foreign investors can feel confident about transparency of those firms while investing. The firms have to be more transparent in their financial reporting practices to reduce information asymmetry.

Limitations:

  • Though there may exist many other factors that may lead to reduction of home bias I have considered only the information asymmetry factor here.
  • It is still debatable whether foreign investors outperform or underperforms local investors which imply that which implies that either foreign investors do not have less information than their local counterparts or no information asymmetry exists at all between them.
  • The study is not empirically tested here. It is based on literature review only.

References:

    1. Sharpe, W., (1964). "Capital asset prices: a theory of market equilibrium under the condition of risk." Journal of Finance 19, 425 442.

    2. Lintner, J., (1965). "The valuation of risky assets and the selection of risky investment in stock portfolio and capital budgets."  Review of Economics and Statistics 47, 103 124.

    3. Black, F., (1974). "International capital market equilibrium with investment barriers." Journal of Financial Economics 1, 337-352.

    4. Stulz, R. M., (1981), "On effects of barriers to international investment." Journal of Finance 36, 923-934.

    5. Lewis, K. K, (1999). "Trying to explain home bias in equities and consumption." Journal of Economic Literature 37, 571-608

    6. Cooper, I., Kaplanis, E., (1986). "Costs to crossborder investment and international equity market equilibrium." In: Edwards, J., Franks, J., Mayer, C., Schaefer, S. (Eds.), Recent Developments in Corporate Finance. Cambridge University Press, Cambridge.

    7. Grinblatt, Mark, and Matti Keloharju, (2001). "How distance, language, and culture influence stockholdings and trades." Journal of Finance 56, 1053-1073.

    8. Faruquee, Hamid, Shijing Li, and Isabel Yan, (2004). "The determinants of International Portfolio Holdings and Home Bias," February,  IMF Working Paper.

    9. Ke D., Ng L. and Wang Q., (2006). "Home Bias in Foreign Investment Decisions."

    10. Cohen, Lauren, (2004). "Loyalty Based Portfolio Choice." Working Paper.

    11. Morse, Adair and Sophie Shive, (2003). "Patriotism in Your Portfolio," Working Paper

    12. Graham, John, Campbell Harvey, and Hai Huang, (2006). "Investor Competence, Trading Frequency, and Home Bias," Working Paper.

    13. Aggarwal, R.; L. Klapper; and P. Wysocki. (2002). "Portfolio Preferences of Foreign Institutional Investors." Working paper, Georgetown University.

    14. French, K., and J. Poterba, (1991) "Investor Diversification and International Equity Markets." American Economics Review: 22226.
     


Titas Rudra
Research Scholar and Teaching Assistant
Indian Institute of Management Calcutta
(IIM Calcutta)
 

Source: E-mail October 23, 2008

           

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