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Equity home bias, incomplete financial markets, and nominal rigidities

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  • Ke Pang
Abstract
This paper analyzes optimal portfolio decisions in a monetary open‐economy framework. It is found that market completeness and the specific form of nominal rigidities, namely, nominal price vs. nominal wage rigidities, matter for justifying the observed structure of equity holdings. When markets are complete, sticky prices generate a negative correlation between the non‐diversifiable labour income and the profit of domestic firms with respect to the productivity shocks, which explains why households invest little abroad. In contrast, when markets are incomplete, rigidities in goods prices result in a counterfactual ‘super home bias’, because domestic equities provide a good hedge against not only the labour income risk but also the relative price risk. Wage rigidities, however, have the opposite effect. Therefore, nominal rigidities in both goods prices and wage rates are needed to address the empirical composition of gross equity positions under incomplete markets. Ce mémoire analyse les décisions optimales de portefeuilles dans le cadre d'une économie monétaire ouverte. On découvre que la complétude des marchés et la forme spécifique des rigidités nominales (rigidité des prix nominaux ou du salaire nominal) portent à conséquence quand on veut expliquer la structure observée des titres détenus. Quand les marchés sont complets, des prix visqueux engendrent une corrélation négative entre les revenus du travail non‐diversifiables et le profit des firmes domestiques face à des chocs de productivité. Voilà qui explique pourquoi les ménages investissent peu à l'étranger. A contrario, quand les marchés sont incomplets, des rigidités dans le prix des biens résultent en un super‐biais vers les titres domestiques, parce que les titres domestiques fournissent une bonne protection non seulement contre le risque dans le revenu du travail mais aussi dans les prix relatifs. Les rigidités de salaires ont l'effet opposé. En conséquence, on doit prendre en compte les rigidités nominales à la fois dans les prix des biens et dans les taux de salaires pour comprendre la composition empirique des portefeuilles quand les marchés sont incomplets.

Suggested Citation

  • Ke Pang, 2011. "Equity home bias, incomplete financial markets, and nominal rigidities," Canadian Journal of Economics/Revue canadienne d'économique, John Wiley & Sons, vol. 44(1), pages 340-363, February.
    • Handle: RePEc:wly:canjec:v:44:y:2011:i:1:p:340-363
    DOI: 10.1111/j.1540-5982.2010.01635.x
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    References listed on IDEAS

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