Santa Cruz Center for International Economics

This paper presents a rational expectations model of asset prices with rationally inattentive investors that, unlike previous papers, can explain both the substantial amount of equity wealth invested domestically and the puzzling time series behavior of the home bias - an initial plateau before 1985, then a decrease until 1994 followed by stabilization on another plateau. When there is a financial liberalization, investors exploit past information to predict current asset payoffs. The resulting endogenous local information advantage generates a gradual decrease of the home bias until its steady state. In the long run, the home bias remains large due to the interaction of the optimal attention allocation with the optimal portfolio choice. Using measures for information capacity, informational advantages and ?financial openness as explanatory variables, we are able to explain at least 46.8% of the variation of the home bias for 19 developed countries from 1988 until 2004. Our estimates show that both variables are significant, with home bias decreasing with financial openness and increasing with information capacity, as predicted by our model.