Question

Giving appropriate examples; describe the following puzzles of international finance

1. Home bias puzzle
2. Exchange rates puzzle
3. Equity premium puzzle

Answer 1

Home Bias

Home bias is the tendency for investors to invest the majority of their portfolio in domestic equities, ignoring the benefits of diversifying into foreign equities. This bias was originally believed to have arisen as a result of the extra difficulties associated with investing in foreign equities, such as legal restrictions and additional transaction costs. Other investors may simply exhibit home bias due to a preference for investing in what they are already familiar with rather than moving into the unknown

Example for home bias puzzle

let's say John Doe lives in Canada. About 80% of his portfolio is stocks, and of those stocks, nearly all are Canadian companies. John says he doesn't invest in companies outside of Canada because he doesn't "get" foreign companies and doesn't understand their accounting conventions.

In a philosophical sense, home bias is an extreme version of the idea of "invest in what you know." Though this is still good advice, investing only in one country can pose significant political and market risks

Example for equity premium puzzle

The Equity Premium Puzzle is a much-researched inconsistency in financial economic theory. Roughly, the "puzzle" centers around the historic long-run differential in returns between U.S. equities, a.k.a stocks, and Treasury bonds. According to generally accepted financial theory, long-term returns of any two asset classes should converge.

In the short-term, the potential return of each individual investment is assumed, in most circumstances, to be proportional to the amount of risk it holds. While some riskier investments could pay off better than less risky investments, the expected return of each investment must be equivalent. Otherwise investors could expect to earn more by investing in certain assets over others.

What happens if some investments have a larger expected returns than others, though? Obviously, investors will prefer the investments that will earn them a higher return, which will bid up the prices of the more attractive investments. As the prices rise, the high-return investments will realize some of their profit potential and become less attractive. For instance, imagine an investment with an expected return of $200. If the price of this investment rises from $100 to $120, it will become less attractive because its expected return has fallen from $100 to $80. At the same time, low-return investments will be unattractive. This will cause selling pressure until the price falls to accommodate an attractive profit potential. This feedback loop between investments will run until all investments have the same expected return per $1 invested.

This process should keep any investments from having expected returns that are different from the average, which is where the equity premium puzzle comes in. The truth is that all investments have not produced equal returns throughout the past 100 years. Economists have estimated that the premium over what equity investments should return according to their risk profile is between +3-7%.

Possible Solutions
Since the equity premium puzzle was first brought to the public attention in 1985, a number of possible solutions have been proposed by various researchers. There are by far two many possibilities to list here, so let's just take a brief look at some of the more popular proposals:

Exchange rate puzzle

Financial theory indicates that there should be a relationship between exchange rate movements and firm returns. The failure to find this relationship empirically has been termed the exchange rate exposure puzzle

exposure puzzle may not be a problem of empirical methodology or sample selection as previous research has suggested, but is simply the result of the endogeneity of operative and financial hedging at the firm level. Given that empirical tests estimate exchange exposures net of corporate hedging, both, firms with low gross exposure that do not need to hedge, as well as firms with large gross exposures that employ one or several forms of hedging, may exhibit only weak exchange rate exposures net of hedging. Consequently, empirical tests yield only small percentages of firms with significant stock price exposures in almost any sample.