Do trade costs in goods market lead to home bias in equities

I focus on three features of international markets: first, people mainly consume home produced goods (the “home bias in consumption puzzle”). Second, they hold a disproportionate share of domestic assets (the “home bias in portfolio puzzle”). Third, countries that are more open to trade are also more financially open. Following Obstfeld and Rogoff [2000], I ask whether one can replicate these three broad facts by simply adding trade costs in a two-country stochastic equilibrium model. Since trade costs generate deviations from “purchasing power parity ” i.e real exchange rate fluctuations, equilibrium portfolios deviate from the market portfolio but not systematically in favor of domestic equities. The direction of the bias in equity portfolios depends crucially on the risk aversion of consumers, on the substituability between domestic and foreign goods and on the size of trade costs. Under reasonable parameters values, trade costs actually worsen the “home bias in portfolio puzzle”. To reconcile facts and theory, I propose a combination of small frictions between financial markets and large trade costs on goods market. Obviously frictions in financial markets lead to “home bias in portfolio ” but it is not the whole story. The interaction between both types of frictions also matters: reducing trade costs increases competition in goods market, which increases the volatility of domestic incomes. Facing higher risks, people want more diversified portfolios and increase their holdings of foreign assets for a given level of frictions in financial markets