Sub-optimal international portfolio allocations and cost of capital

Finance theory suggests that the optimal international equity portfolio investment by home and foreign investors reduces cost of capital through international risk sharing and capital market integration. However, the empirical evidence is inconsistent with theory as a number of studies show investors exhibit cross-country biases in their international portfolio investments, known as home and foreign biases. In this study we investigate the implications of home and foreign biases on cost of capital. Using data from 44 countries over a period of 2001-2014, we provide strong evidence that countries which experience higher home bias are associated with a higher cost of capital. Similarly, we also find that countries which are more favoured by foreign investors, relative to the theoretical predictions, are associated with a lower cost of capital.