The Effects of Risk-Hedging Motives and Trade Costs on Foreign Bond Holdings

Abstract

This study investigates the determinants of foreign bond holdings, focusing on the hedge motive against real exchange rate risk and trade costs. Unlike previous studies, this paper analyzes the effects of the hedge ratio and trade costs on foreign bond holdings within both empirical analysis and a unified analytical framework. To achieve this, we conduct a panel regression analysis, which provides empirical evidence that increases in the hedge ratio and trade costs reduce U.S. foreign bond holding. On the theoretical side, we derive a closed-form solution for foreign bond holdings with respect to trade costs and the hedge ratio using a second-order approximation within a dynamic stochastic general equilibrium (DSGE) framework. Simulation results reveal that the hedge ratio and trade costs negatively affect foreign bond holdings under certain model parameters, consistent with empirical findings. These results suggest that home-country investors place greater weight on domestic bonds than on foreign bonds, as a higher hedge ratio implies that domestic bonds are more effective in hedging real exchange rate risks. In addition, the results indicate that active trade in goods can promote bond market integration across countries by reducing asymmetric information between trading partners.