Theory and empirics of cross country trade in bonds and equities

Rahbari, Ebrahim (2010) Theory and empirics of cross country trade in bonds and equities. Doctoral thesis, University of London: London Business School.

Abstract

This thesis extends the theory and empirics of cross country asset positions, paying particular attention to the fact that a large share of domestic equity is held by domestic investors ("equity home bias"). The thesis is built around three key insights. Firstly, we show that in a broad class of models equilibrium asset positions can be related to a small number of sources of risk reflecting fluctuations in consumption expenditure, nonfinancial income and government spending. Secondly, we show that it is important to account for the presence of all assets traded, as individual asset positions depend on the comovement of the portion of the returns of that asset and certain sources of risk that are orthogonal to the returns of the other assets traded. Thirdly, we show that the nature of the asset menu traded matters greatly, e.g. the maturity of bonds traded. We focus on both theoretical and empirical results. We present a two country dynamic general equilibrium model with nominal rigidities, endogenous capital accumulation and trade in nominal bonds and equity that produces realistic equity home bias, while replicating many salient features of the international business cycle. Later, we introduce trade in long term nominal bonds into a simple two country model and show that the model generally predicts that domestic investors have a net short position in domestic currency, as found in data for the U.S. On the empirical side, we use theory based sign restrictions to identify the impulse responses of asset returns and sources of risk to different shocks and find that the responses of all variables are similar for all shocks considered and similar to the nominal exchange rate, suggesting an important role for nominal exchange rate fluctuations. We use quarterly data to test the relative importance of three hedging based explanations of equity home bias and find a potentially important role for the motive to hedge human capital returns in the G7 countries. We also find that allowing a central bank to hedge sudden capital account reversals ("sudden stops") increases the optimal dollar in the central bank portfolio for 24 emerging market economies on average, but also find regional differences.