Incomplete observation, filtering, and the home bias puzzle
Introduction
The home bias puzzle is one of the several puzzles or anomalies that have been perplexing many economists. Although standard capital asset pricing model predicts that investors would hold portfolios essentially identical in composition, investors' portfolios have been dominated by domestic assets. Several explanations for the home bias puzzle have been proposed (e.g. Tesar, 1993, Lewis, 1996, Devereux and Saito, 1997); however, all of them explicitly or implicitly assume that investors have `perfect' information about risky assets, both domestic and foreign, and that therefore there is no informational differences between domestic and foreign investors. In contrast, this paper, employing an approach and a model that are completely different from those previous studies, postulates that investors cannot have perfect information about foreign assets and argues that incomplete information can be a reasonable explanation for the home bias.
Section snippets
The model
Let (Ω,,P) be a complete probability space, and let (t),0≤t≤T, be a nondecreasing family of right continuous σ-algebras of subsets of Ω.
For simplicity, suppose there are two countries, Home and Foreign, each has a single risky asset, and that there is also a riskless bond. Investors in both countries can buy Home and Foreign risky asset and a riskless bond without any costs or restrictions; however, when they choose their portfolios, they cannot have perfect information about an asset in
Optimal filtering equations
In this section we derive optimal filtering equations for {θt}. The investors are assumed to estimate (`filter') {θt} based on the observation results {ξs}, s≤t, of the partially observable process at each moment t, 0≤t≤T, in order to form a posterior mean {mt} continuously.
Let us denote the optimal estimate of {θt} from {ξt} byand the error of estimation (or the filtering error) byWe assume γt>0 since γt=0 means that Home investors can estimate the process {θt}
Optimal portfolio choice
In this section we consider investor's optimal portfolio choice in continuous time settings using the methodology developed by Merton (1971)2.
To ensure comparatively, we assume the two countries are symmetric (in terms of preferences and informational structure) and
Conclusion
We are now in the position to compare π1 and π2. Recall that Home asset is described by Eq. (1)and Foreign asset is given by Eq. (7). Therefore, μ1=μ2=a(t), σ1=b(t), andIt should be emphasized that the second term on the right-hand side in Eq. (9)is always positive since A(t),B(t),mt2, and γt are positive. Hence, the estimated variances of Foreign asset are always larger than those of Home asset (although they are in fact the same) when Home investors cannot observe
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Cited by (3)
Valuation of power option for uncertain financial market
2016, Applied Mathematics and ComputationCitation Excerpt :The home bias is another puzzle in financial fields, based on the traditional portfolio theory investors should choose the optimal allocation the theory suggested by Sharpe [23] and Lintner [12], but a lot of surveys showed that investors usually overweight the domestic stock markets and companies. Many scholars try to explain the home bias puzzle, for example, Ahearne et al. [1], Devereux and Saito [8], Lewis [11] and Ueda [25] gave their explanations. But we argue that investors’ belief degrees play an important role in decision making for financial practice.
International asset allocation for incompletely-informed investors
2010, Journal of Financial MarketsCitation Excerpt :Unlike Alder and Dumas (1983), who ignore the changing quality of information, we demonstrate how partially-informed investors may hedge their choices according to the changing quality or precision of the available information, and therefore tend to hold relatively more home assets. Furthermore, while Ueda (1999) assumes that no correlation exists between true and observed local price processes — claiming that home bias is completely attributable to the estimation errors of investors on the true process of foreign asset prices — we argue that home bias may be the result of the unobservable expected returns of the home and foreign assets. Furthermore, we consider that the updating mechanism of partially-informed agents may relate not only to their prior beliefs, but also to their subjective under-reactions to new information (i.e., conservatism) when updating their estimations of the expected returns of foreign assets.
Valuation of stock loan under uncertain environment
2018, Soft Computing