From Home Bias to Euro Bias: Disentangling the Effects of Monetary Union on the European Financial Markets

Following the launch of the Euro in 1999, integration\namong Euro area financial markets increased considerably. As a result, portfolio home bias declined across the European financial markets. However, greater market integration has generated a new bias: portfolio Euro bias, a situation where Euro investors tend to hold large proportion of assets issued within the Euro region. The first part of this paper presents an empirical analysis of the economic factors at play behind the switch from home\nbias to Euro bias. We find that decline in default risk and\ntransaction cost are two key determinants of the rise in portfolio Euro bias. The second part of the paper goes deeper into the effects of Euro bias on Euro area bond and equity markets. We observe that both government and corporate bond markets revealed clear signs of strain during the recent financial turmoil. Our results also reveal\nthat the risk-reduction potential from geographic diversification within the Euro equity market is lower than that of the Euro sector diversification.