Literature has found that the large investments in the US cannot be explained by standard portfolio allocation models and diversification motives. Indeed, according to the mean variance portfolio theory, the market portfolio implies that investors expect a return in the US market hundreds of basis points higher than its empirical counterpart. In this paper, we explain the overweighting of US market (and underweighting of some other economies accordingly) in the market portfolio by excitation asymmetry. In particular, we employ a mutually exciting jump diffusion model to generate jump excitations both over time and across different equity markets. We characterize the dominance role of US over peripheral markets by imposing a larger cross section excitor of US price jumps, so that crashes in the US can get reflected quickly in smaller economies but not the other way round. We solve in closed-form the portfolio optimization problem in this market in terms of optimal portfolio exposure to risk factors. We show that the optimal portfolio (1) is sufficiently diversified, in the sense that it consists of a large number of individual assets in order to diversify away idiosyncratic risks and that it exploits the diversification potentials in the instantaneous covariance matrix of international asset returns; (2) is biased, in the sense that dominant regions, such as US, which transmit their risks more easily to other markets, have larger shares in the optimal portfolio than implied by classical portfolio choice models, giving rise to a phenomenon named “the Dominant Region Bias”. By calibrating the model to historical prices of MSCI US, Japan and Europe, we show that our model is able to reproduce the observed biases in the market portfolio. (joint with Roger Laeven and Rob van den Goorbergh)

Field: Finance

Discussant: Nico Dragt (VU)