http://people.ucsc.edu/~thomaswu/Teaching/241b/public_html/public_html/Research/integration.pdf


In this paper, we show that imperfect Önancial integration and informational asymmetries are not two competing theories but rather two ingredients of a single explanation of
the home bias puzzle. We develop a rational expectations model of asset prices with rationally inattentive investors and small Önancial frictions. In the presence of small transaction
costs on foreign asset holdings, investors tilt their portfolio towards domestic assets. The
higher the domestic asset demand, the more information is processed about these assets.
Thus, small Önancial frictions generate an endogenous initial information asymmetry. The
endogenous initial information advantage in domestic assets leads investors to hold even
more domestic assets and feedbacks once again into an even greater incentive to process
information about these assets. Calibrations of our model show that transaction costs or
tax disadvantages that would reduce the domestic investorís net return on its foreign asset
holdings just by 10% can generate a home bias as high as 70% or 80%.