International Portfolio Diversification and Multilateral Effects of Correlations / Paul R. Bergin, Ju Hyun Pyun.

Format:

Book

Author/Creator:

Bergin, Paul R.

Contributor:

National Bureau of Economic Research.

Pyun, Ju Hyun.

Series:

Working Paper Series (National Bureau of Economic Research) no. w17907.

NBER working paper series no. w17907

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2012.

Summary:

Not only are investors biased toward home assets, but when they do invest abroad, they appear to favor countries with returns more correlated with home assets. Often attributed to a preference for familiarity, this 'correlation puzzle' further reduces effective diversification. However, a multi-country DSGE model of portfolio choice makes clear that the effects of a bilateral stock return correlation must be studied in the context of the full covariance structure. For example, the attractiveness of a foreign country as a hedge depends upon its hedging potential relative to other potential destination countries. This paper develops a new empirical approach based upon a multi-country theoretical model that controls for the full covariance structure in a theoretically rigorous yet tractable manner. Estimation under this approach overturns the correlation puzzle, and finds that international investors do seek the diversification benefits of low cross-country correlations as theory would predict. Since covariances are central to modern theories of portfolio choice, this empirical methodology should be useful also for other applications.

Notes:

Print version record

March 2012.