The role of institutional investors in international trading: an explanation of the home bias puzzle

We postulate that the growing participation of institutional investors in capital markets along with their particular o~jective function might help to explain the home equity bias puzzle. We model an institutional investor as a risk averse investor that has access to international financial marckets and tries to maximize expected utility resulting from the difference between final wealth and an exogenously given index formed exlusively by domestic securities (the benchmark index); we show that for some values of the covariances and betas, this objective will induce a home bias. We study the effects of this optimal strategy on a simple one-period equilibrium and obtain a multibeta CAPM; as a novelty, one of the betas is refered to the excess return of the benchmark index. We test this model using data from six countries and we show that the index helps to explain the excess return of domestic securites. This effect is obvious when we compare a recent subperiod (when institutional investors have a larger weight in capital markets) with a previous subperiod .