(Asymmetric) trade costs, real exchange rate hedging, and equity home bias in a multicountry model

There has been controversy between (two-country) theory and the empirics about whether hedging against real exchange rate fluctuations in the goods market influences foreign equity holdings. This study reconciles the theory with the empirics by introducing a multicountry framework with asymmetric trade costs. We find that the incentive to hold foreign equities to hedge real exchange rate risk is negligible because multiple trade partners act as a hedging channel for real exchange rate fluctuations. Further, our theory calls for a country's covariance-variance ratio to be constructed as the sum of the bilateral covariance-variance ratios of the multiple partners. The empirical analysis of 24 advanced countries confirms the theoretical prediction.