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Review of Quantitative Finance and Accounting
Published in: Review of Quantitative Finance and Accounting 1/2020

07-02-2019 | Original Research

Suboptimal international equity portfolio diversification and stock market development

Authors: Frank O. Kwabi, Chandra Thapa, Krishna Paudyal, Suman Neupane

Published in: Review of Quantitative Finance and Accounting | Issue 1/2020

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Abstract

This paper examines whether the widely reported phenomena of home and foreign biases (i.e. suboptimal international equity portfolio diversification) hold any ramifications for the development of stock markets. The results, analysed using macro- and micro-level data, support the view that stock markets that are characterised by a higher degree of home bias are associated with lower levels of development. On the other hand, markets where foreign investors show a higher degree of allocation preference, relative to the prescribed benchmark (foreign bias), are found to be more developed. The results, which are robust to the use of shock based identification strategy, indicate that policy measures that promote optimal international equity portfolio diversification could be crucial in developing the depth and breadth of domestic stock markets.
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Footnotes
1
For time varying diversification effects see Chiou and Lee (2013) and for benefits from developing markets; perspective see Chiou and Boasson (2015).
 
2
Home bias indicates that local investors hold a significantly higher percentage of domestic securities in their portfolios relative to the theoretical prescription of the International Capital Asset Pricing Model (ICAPM) benchmark. Correspondingly, foreign bias relates to the tendency of foreign investors to over or under weight foreign markets compared to the ICAPM benchmark. For further details on the differences between home and foreign bias, see Chan et al. (2005).
 
3
See Cooper and Kaplanis (1986) for a detailed discussion on how the ICAPM is used to derive the value based international portfolio allocation.
 
4
See Kwabi et al. (2018) for recent evidence and Cooper et al. (2012) for an extensive review.
 
5
Examples of such barriers include weak investor protection, poor accounting standards, higher trading costs, and lower market liquidity etc. (Bekaert and Harvey 2003).
 
6
The McKinsey Global Institute (2013) reports that the interplay between financial deepening and financial globalization is still an uncharted domain in the academic literature. The report notes that foreign investors provide capital, expertise and competition, which could spur financial deepening of the local market, particularly in countries with weaker financial development. It argues that the presence of foreign investors enhances the domestic market, beyond the metric of mere size, by not only infusing the much needed capital for investment and growth but also by promoting competition, raising the bar of corporate governance and transparency, and bringing the domestic firms to the international financial markets.
 
7
These economic magnitudes are the first estimates available in the literature. As with any observation-based regression study that generates significant challenge of establishing credible causality (including quasi-experimental designs), these estimates are also subject to empirical assumptions and limited to our data set and sample period. Therefore, they should be viewed as indicators of the relation and used with due caution.
 
8
Our study also differs from those observing changes in market development measures post financial liberalization. Instead of investigating the changes post liberalization we investigate the implications of home and foreign bias puzzles on stock market development.
 
9
A detailed description of this data set can be found in Bekaert and Wang (2010).
 
10
The total investments of source and host countries comprise over 95% of the total assets and liabilities holdings respectively reported by CPIS.
 
11
The EPFR is used by existing researchers to address a number of different issues (Gelos and Wei 2005; Jotikasthira et al. 2012).
 
12
Further, since the funds are domiciled in nine countries, we are unable to construct a robust measure of home bias, which is restricted by the smaller number of observations for our empirical analysis (90 observations only).
 
13
A zero \( EHB_{jt} \) would indicate that investors have no bias towards their home market, while positive values show the presence of home bias.
 
14
Note, on aggregate the foreign bias should be negative for each country (j) which exhibits home bias. However, given the fact that CPIS does not report the holding for all countries in the world, on average, the foreign bias could be positive or negative. Such figures are also reported in the existing literature (Chan et al. 2005).
 
15
These are the only aggregate country level proxies for average transaction cost measures sourced from the literature and are available for country level studies in the panel data framework.
 
16
See, for instance, Claessens et al. (2006).
 
17
Foreign direct investments exclude equity portfolio investment.
 
18
Credits to the private sector include commercial banks’ short- and long-term loans, purchase of non-equity securities, trade credits and other accounts receivable that establish a claim for repayment provided to the private sector.
 
19
We use the Morgan Stanley Capital Investment classification to identify emerging and developed markets.
 
20
The top ten countries ranked by TRGDP are Hong Kong, United States, Switzerland, United Kingdom, South Korea, Spain, Netherlands, Sweden, Spain, and Finland while the bottom ten countries are Romania, Argentina, Peru, Bulgaria, Mexico, Philippines, Poland, Czech Republic, Indonesia and Chile.
 
21
For the sake brevity, the table is not reported but can be obtained from the authors on request.
 
22
We address the issue of endogeneity later, in Sect. 3.3.
 
23
Naturally, as with any empirical investigation using non-experimental data, these estimates are subject to empirical assumptions and limited to our data set and sample period.
 
24
Literature notes that stock market development itself could drive home and foreign bias (Chan et al. 2005).
 
25
We are grateful to the anonymous reviewer who suggested the use of the development measure in the classification of the countries.
 
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Metadata
Title
Suboptimal international equity portfolio diversification and stock market development
Authors
Frank O. Kwabi
Chandra Thapa
Krishna Paudyal
Suman Neupane
Publication date
07-02-2019
Publisher
Springer US
Published in
Review of Quantitative Finance and Accounting / Issue 1/2020
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI
https://doi.org/10.1007/s11156-019-00793-9

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