In today's globalised world, investors are often advised to hold a combination of domestic and foreign equity to spread out and balance their risk. However, numerous reports have shown a bias towards home equity as a result of either institutional barriers or investor behavior. What has not been clear is how home bias affects asset pricing in equilibrium. Does it lead to higher returns on home assets, or lower ones? How does it affect returns in other countries?

Bruno Solnik and Luo Zuo have devised a model that attempts to answer these questions. Their goal is to discuss the relationship between the magnitude of home bias in each country and global asset pricing.

"Our model is inspired by regret theory. We assume investors treat domestic and foreign assets differently and experience regret when their foreign investment position underperforms domestic assets - that is, they feel the pain of regret of having invested abroad," they said.

This is a departure from the traditional global capital asset pricing model, which looks at investment barriers and other forms of segmentation rather than familiarity and regret and tends to find a positive premium for the segmented market - quite the opposite of what the authors found.

Their model finds that foreign aversion does not so much affect asset pricing directly as it does asset holdings. There is then a knock-on effect on pricing when foreign aversion levels differ among countries.

"When investors from different countries have the same level of home preference, no pricing adjustment is needed. But when it differs across countries, a home bias premium enters international asset pricing," they said.

"Investors from a more foreign-averse country have stronger demand for domestic equity and are therefore willing to accept a lower expected return, which will make their equity less attractive to investors from other countries. Hence foreign investors will have a lower demand for equity from that country and exhibit some home bias themselves that accommodates the home bias of the first country in equilibrium."

The model thus predicts that home bias will affect the balance of home and foreign holdings. It is enough for just one country to be foreign averse to induce home bias in every country because this drives foreign investors to look at their home markets.

The cycle of a higher local home preference inducing both a lower expected return on the local market and a higher local home bias was tested on data from 17 developed markets and 11 emerging markets (the latter tend to have much stronger home bias due to restrictions on foreign investments by residents). Home bias was found to be extensive and varied, ranging from an average 70 per cent in developed markets to more than 90 per cent in emerging ones. The data supported the model's predictions.

"We find expected returns and home bias are negatively correlated, controlling for world beta and market segmentation," the authors said. "We also find an annual decrease in home bias is associated with a lower realized return in that year, after controlling for changes in segmentation and changes in expected cash flows. This suggests that if a country's home bias decreases in a given year, its expected return will increase, which is achieved by a decrease in its local stock price."

They added that the support for their model did not mean a rejection of the segmentation approach. Both effects could be playing out simultaneously, they said.