UC Berkeley

This paper presents a model of international portfolios with real exchange rate and non-financial risks that account for observed levels of equity home bias. Bonds matter: in equilibrium, investors structure their bond portfolio to hedge real exchange rate risks. Equity home bias arises when non-financial income risk is negatively correlated with equity returns, after controlling for bond returns. Our framework allows us to derive equilibrium bond and equity portfolios in terms of directly measurable hedge ratios. An empirical application to G-7 countries finds strong empirical support for the theory. We are able to account for a significant share of the equity home bias and obtain an aggregate currency exposure of bond portfolios comparable to the data.