The puzzling evolution of the home bias, information processing and financial openness

Abstract

This paper explains the home equity bias and its puzzling evolution in a model where investors face an information constraint and have an initial local informational advantage. After financial liberalization, local investors have a magnified informational advantage since information processed under autarky remains useful after liberalization. A gradual shift towards foreign assets occurs as the relevance of autarkic information declines over time. In the long run, home bias remains large due to the interaction between information and portfolio choices. Empirical evidence supports the main predictions of our model, namely that bias increases with information capacity and decreases with financial openness.