International asset allocation and equity home bias in emerging markets

This thesis investigates equity home bias from an asset allocation perspective in emerging markets. Firstly, a review of equity home bias in modem finance literature is presented, followed by a discussion of the relative strengths and weaknesses of international asset pricing and optimal allocation models. Secondly, the thesis tests static and conditional Capital Asset Pricing Models (CAPMs) for 23 emerging markets over the period February 1997 - December 2007. The study reveals little support for the static CAPM compared to the conditional version; in which the conditional CAPM seems to explain excess returns' dynamics and implies higher volatility persistence in emerging markets compared to developed markets as documented in the literature. Accordingly, the study employs a modified trivariate generalised autoregressive conditional heteroscedasticity (GARCH) model for the period April 1994 - July 2008, in order to estimate time-varying optimal weights in a portfolio of three assets; namely the return on the domestic index, the return on the US index, and the return on the UK index. The number of assets in the portfolio is increased to reach 13 assets in some markets through the estimation of the Dynamic Conditional Correlation (DCC) model denominated in local currencies and in US Dollars. The three models show that the optimal weights on domestic equities divert substantially from the actual equity holdings as documented in survey reports; in addition to the effect of including more assets in the portfolio, and the influence of exchange rate risk on optimal weights. Lastly, the thesis examines the variables that influence equity domestic holdings through the panel estimation of the feasible Generalised Least Squares (GLS) method in order to control for heteroscedasticity. The study suggests that factors related to information asymmetries, economic risks at home, exchange rate volatility, and markets' inefficiencies are the main factors affecting equity domestic bias in emerging markets.