International Capital Budgeting: The Case of Home Bias - Research Paper Example

International Capital Budgeting: The Case of Home Bias Introduction International capital budgeting is a popular topic of professional analysis. Much has been written and said about the best instruments of international capital budgeting and factors influencing international capital decisions. Equity portfolio management is an important element of international capital budgeting, which largely predetermines its effectiveness and relevance. The effects and implications of home bias for capital budgeting at the international scale have been described in abundance. In their article, Cooper and Kaplanis investigate the relationship between home bias in equity portfolio management, international capital market equilibrium, and inflation hedging. The authors develop a new model of international portfolio management and discuss the practical implications of using their model in international capital budgeting decisions. Synopsis According to Cooper and Kaplanis, the degree to which equity portfolio tend to be concentrated in domestic capital markets remains the most striking feature of contemporary international portfolio investment. This is what is called “home bias”, or propensity of domestic investors to devote a larger share of international capital to domestic equities. More often than not, home bias is believed to be a serious impediment to effective capital budgeting, since it prevents and reduces international diversification (Cooper & Kaplanis 46). The situation is further complicated by inflation risks and the dangers posed by home bias to purchasing power parity (Cooper & Kaplanis 46). The significance of the relationship between home bias, interest rate parity, home and foreign currency approaches cannot be overstated. This is why Cooper and Kaplanis decided to investigate home bias in equity portfolio management, as part of their research into international capital budgeting. Cooper and Kaplanis pursued three important objectives. First, the authors sought to evaluate “whether the hedging of purchasing power parity deviations caused by stochastic inflation can explain the home bias in equity portfolios” (Cooper & Kaplanis 47). Second, Cooper and Kaplanis tried to develop a model of international portfolio management accounting for inflation risks and deadweight costs (47). Third, the authors tried to estimate the scope of deadweight costs and, simultaneously, explain the presence of home bias by motives other than inflation risks (Cooper & Kaplanis 47). The Adler and Dumas model of portfolio management serves the fundamental element of research (Cooper & Kaplanis 47). However, instead of using international financial market tests based on ex-post returns, Cooper and Kaplanis used portfolio holdings predictions (47). The researchers recognized that information covering portfolio holdings could be incomplete, but it was a better alternative than the information concerning ex-post average returns (Cooper & Kaplanis 47). Cooper and Kaplanis suggested that the use of portfolio holdings predictions could become a better instrument of managing international capital budgeting decisions, and could also help to explain why home bias in international investments continues to persist (47). The results of Cooper and Kaplanis’s research have far-reaching implications for international investments. First, taking the Adler and Dumas model as the basis for international market equilibrium, whether or not firms decide to make international investments depends upon their competitive position (Cooper & Kaplanis 56). The latter also implies that, depending on their market position, different firms will expect different cash flows as a result of one and the same international capital budgeting decision (Cooper & Kaplanis 56). Also, in their international capital budgeting approaches, national and international costs of investments and possible tax effects must be taken into account (Cooper & Kaplanis 57). Second, bearing in mind the deadweight costs and deadweight cost equilibrium, all international investment decisions must rely on the country of origin of the investing company (Cooper & Kaplanis 57). Therefore, deadweight costs are equally important in international budgeting decisions as home and foreign currency rates and purchasing power parity deviations (Cooper & Kaplanis 57). Three arguments supporting the opinion So, is home bias so important in capital budgeting decisions and can transnational corporations limit their investments to domestic markets? Here, three important arguments need to be considered. First, investors in different countries consume different services and goods; consequentially, the investment portfolios they create differ greatly and are primarily designed to tackle with hedge inflation risks (Cooper & Kaplanis 48). Therefore, greater share of domestic investments in international capital can be justified by investors’ natural striving to reduce hedge inflation risks. Second, international capital budgeting is associated with considerable cross-border costs, which profoundly influence the structure of international capital and investment portfolios designed by organizations (Cooper & Kaplan 49). These costs can be numerous and varied, from taxes and legal restrictions to informal disadvantages and the lack of access to national markets. This is why, in their international capital budgeting decisions, organizations may experience home bias which eventually provides greater net return on equities, compared with international investments. Third, nontraded goods make the international capital budgeting process particularly complicated: “the desire of investors to hedge against the price uncertainty of nontraded goods leads to home bias” (Cooper & Kaplanis 49). In this situation, it seems that home bias can be extremely beneficial to the quality of international capital decisions made by firms, but this is not always the case. Three arguments against home bias Home bias is not always as beneficial as organizations and private investors expect. In their international capital decisions, investors must be particularly cautious while investing in home equities. This is like putting all eggs into one basket, which can easily break once it grows too heavy. To begin with, international portfolio diversification reduces the risks of deviation in investment returns, since the standard deviation of returns from the international portfolio is much lower than that for a single, home-based stock. Second, it is through international portfolio diversification that organizations can enhance the efficiency of all capital budgeting processes at an international scale, as long as diversified portfolios reflect a better picture of the international market. Finally, home bias can become a serious barrier to improved capital budgeting, because only internationally diversified portfolios can help investors, either corporate or individual, to avoid or at least reduce negative correlations in international stock markets. Personal opinion I accept and recognize the significance of home bias in international capital budgeting decisions. However, I also believe that rational investors cannot disproportionately invest in domestic equities, because the latter are associated with negative return correlations. I assume that, despite its relative benefits, home bias can be highly negative in terms of international capital budgeting and reduce their effectiveness. However, future research must shed new light on the relationship between home bias and the quality of international capital budgeting. Conclusion The effects and implications of home bias for capital budgeting at the international scale have been described in abundance. In their article, Cooper and Kaplanis investigate the relationship between home bias in equity portfolio management, international capital market equilibrium, and inflation hedging. The authors develop a new model of international portfolio management and discuss the practical implications of using their model in international capital budgeting decisions. Future research must shed new light on the relationship between home bias and the quality of international capital budgeting. Works Cited Cooper, Ian and Evi Kaplanis. “Home Bias in Equity Portfolios, Inflation Hedging, and International Capital Market Equilibrium.” The Review of Financial Studies, 7.1 (2004): 45-60. Print. Read More