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Despite the liberalization of capital flows among OECD countries, equity home bias remains sizable. The authors depart from the two familiar explanations of equity home bias: transaction costs that impede international diversification, and terms of trade responses to supply shocks that provide risk sharing, so that there is little incentive to hold diversified portfolios. They show that the interaction of the following ingredients generates a realistic equity home bias: capital accumulation, shocks to the efficiency of physical investment, as well as international trade in stocks and bonds. In the model, domestic stocks are used to hedge fluctuations in local wage income. Terms of trade risk is hedged using bonds denominated in local goods and in foreign goods.
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