The theory of international finance is based on differences between the residents of different countries in opportunity sets, tastes, and information. Such differences may lead to systematic differences between the portfolios held by investors in different countries,as well as to different trading behavior. Differences in opportunity sets may arise because of cross border frictions and barriers such as taxes and capital controls (Black (1974), Stulz (1981)).
Although these impediments to the flow of capital have become progressively less important among developed countries over the last 25 years, there continue to exist pronounced differences in the portfolios of residents of different countries, which are characterized most simply in terms of home bias. French and Poterba (1991) and Cooper and Kaplanis (1994) argue that the remaining barriers are insufficient to explain the observed degree of home bias.
Adler and Dumas (1983) point out that differences in tastes between residents of different countries may create deviations from purchasing power parity that lead investors in different countries to hold different portfolios in order to hedge against domestic purchasing power risk. But, while domestic inflation risk could in principle account for the home bias phenomenon, Cooper and Kaplanis (1994) show that the empirical evidence is consistent with this explanation only if investors have implausible low risk aversion (and equity returns are negatively correlated with domestic inflation.)