Country Portfolios with Imperfect Corporate Governance

Rahul Mukherjee

No 08-2011, IHEID Working Papers from Economics Section, The Graduate Institute of International Studies

Abstract: Equity home bias is one of the most enduring puzzles in international finance. In this paper, I start out by documenting a novel stylized fact about home bias: countries with weaker domestic institutions hold fewer foreign assets. I then explore a macroeconomic mechanism by which the presence of agency problems in firms may explain this pattern. To do so, I develop a two-country dynamic stochastic general equilibrium model of international portfolio choice with corporate governance frictions and two distinct agents - outside investors (outsiders) and large controlling shareholders (insiders). Insiders can extract private benefits of control from a firm at a cost which is lower when institutions are weaker. I show that the interaction between the insider's private benefits and investment decisions leads asset and labor income for outsiders to be more negatively correlated in countries with weaker institutions. Thus, outsiders in these countries bias their portfolios more towards home assets to hedge their labor income risk. Calibrating the model to match existing estimates of private benefits of control, I am also able to replicate the cross-country dispersion in insider ownership and investment volatility seen in the data.

Keywords: home bias; institutional quality; corporate governance (search for similar items in EconPapers)
JEL-codes: F21 F41 G15 (search for similar items in EconPapers)
Pages: 53 pages
Date: 2011-04-08
New Economics Papers: this item is included in nep-ifn
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http://repec.graduateinstitute.ch/pdfs/Working_papers/HEIDWP08-2011.pdf (application/pdf)

Related works:
Journal Article: Institutions, Corporate Governance and Capital Flows (2015)
Working Paper: Institutions, Corporate Governance and Capital Flows (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:gii:giihei:heidwp08-2011

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