Global Capitalization Weighted United States European Monetary Union United Kingdom Japan Equilibrium excess return 3.98% Volatility 9.33% Sharpe ratio 0.426 4.03% 9.48% 0.425 3.93% 9.29% 0.424 4.02% 9.65% 0.417 3.81% 9.05% 0.421 INTERNATIONAL DIVERSIFICATION AND HOME BIAS___________ Few investors' holdings actually reflect global capitalization weights; most portfolios have disproportionately large domestic exposure. This tendency to concentrate assets domestically-referred to as home bias-influences the currency hedging policy because fewer underlying assets are invested abroad. Is there an underlying economic rationale for home bias? Are there rules of thumb to help determine a suitable home bias level and how does the home bias affect the currency hedging policy? Let's look first at how home bias affects the Sharpe ratio of the strategic, or long-term, asset allocation.1 Using equilibrium returns (discussed in Chapter 6), we can calculate a global capitalization weighted portfolio's risk-adjusted performance and then compare it to the risk-adjusted performance of a portfolio whose fixed income or equity portion is invested solely in domestic assets. Table 11.1 shows how fixed income home bias affects the Sharpe ratio. It compares the expected excess return, volatility, and Sharpe ratio for the global capitalization weighted portfolio of marketable securities (discussed in Chapter 8) to the same elements of portfolios with global equity investments and domestic-only fixed income holdings. The capitalization weight split is held constant-32 percent fixed income and 68 percent global equities (held in their capitalization weights)-and all assets are assumed to be currency hedged. Domestic portfolios are shown for euro-, sterling-, U.S. dollar-, and yen-based investors. To facilitate the analysis, all portfolios are held on a currency-hedged basis. The figures suggest that global diversification in the fixed income portion of a portfolio does not materially affect the Sharpe ratio (at least when equilibrium returns are used). For example, a euro-based investor's Sharpe ratio declines from 0.426 to 0.424 when bonds are held in the Euroland fixed income market only. Similarly modest changes in the Sharpe ratio occur from the other three currency perspectives. Although Table 11.1 seems to suggest that there's no benefit from diversifying into international bonds, there are a couple of important caveats. First, a portfolio's equity allocation greatly affects the impact of international fixed income exposure. Consider Figure 11.1, which plots portfolio Sharpe ratios (with and without international bonds) against equity allocations. When equity allocations ]The Sharpe ratio is just a portfolio's excess return (i.e., total return less the cash rate) divided by the portfolio volatility.