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Time-varying correlations and optimal allocation in emerging market equities for the US investors

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  • Heung-Joo Cha

    (University of St. Thomas, St. Paul, MN, USA)

  • Thadavillil Jithendranathan

    (University of St. Thomas, St. Paul, MN, USA)

Abstract

Low correlations between asset returns increase the portfolio diversification benefits and for US investors emerging market equities are one such class of assets. Several studies indicate that the correlations between asset returns are time varying and using unconditional estimates of correlation in a portfolio optimization model can result in misallocation of assets. To overcome this problem we use multivariate Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models to estimate the time-varying correlations and use the same in portfolio optimization models. Ex-post return calculations show that unrestricted portfolios created with emerging stock indices and S&P 500 index outperform the S&P 500 index by itself. Since investors exhibit strong home bias in their portfolio choice, restricted optimization models are tested. Results indicate that if the total investment in emerging markets is restricted, a minimum investment of 20% in emerging markets is required to obtain significant diversification benefit. With investments in each of the emerging market restricted to less than 3%, there was no significant diversification benefit. Copyright © 2007 John Wiley & Sons, Ltd.

Suggested Citation

  • Heung-Joo Cha & Thadavillil Jithendranathan, 2009. "Time-varying correlations and optimal allocation in emerging market equities for the US investors," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 14(2), pages 172-187.
    • Handle: RePEc:ijf:ijfiec:v:14:y:2009:i:2:p:172-187
    DOI: 10.1002/ijfe.343
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    2. Yang Zhao & Charalampos Stasinakis & Georgios Sermpinis & Filipa Da Silva Fernandes, 2019. "Revisiting Fama–French factors' predictability with Bayesian modelling and copula‐based portfolio optimization," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 24(4), pages 1443-1463, October.
    3. Jin, Xiaoye & An, Ximeng, 2016. "Global financial crisis and emerging stock market contagion: A volatility impulse response function approach," Research in International Business and Finance, Elsevier, vol. 36(C), pages 179-195.
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    5. Sercan Demiralay & Veysel Ulusoy, 2017. "How Has the Behavior of Cross-Market Correlations Altered During Financial and Debt Crises?," Manchester School, University of Manchester, vol. 85(6), pages 765-794, December.
    6. Sadorsky, Perry, 2012. "Correlations and volatility spillovers between oil prices and the stock prices of clean energy and technology companies," Energy Economics, Elsevier, vol. 34(1), pages 248-255.
    7. Kenta Inoue, 2014. "Is Correlation Puzzle Really Puzzling? Reassessing Motives Of Foreign Asset Holdings By Us Investors," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 19(2), pages 160-172, March.
    8. Vera Mirovic & Dejan Zivkov & Jovan Njegic, 2017. "Construction of Commodity Portfolio and Its Hedge Effectiveness Gauging – Revisiting DCC Models," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 67(5), pages 396-422, October.
    9. Kumar, Satish & Pradhan, Ashis Kumar & Tiwari, Aviral Kumar & Kang, Sang Hoon, 2019. "Correlations and volatility spillovers between oil, natural gas, and stock prices in India," Resources Policy, Elsevier, vol. 62(C), pages 282-291.
    10. Azra Zaimovic & Adna Omanovic & Almira Arnaut-Berilo, 2021. "How Many Stocks Are Sufficient for Equity Portfolio Diversification? A Review of the Literature," JRFM, MDPI, vol. 14(11), pages 1-30, November.
    11. Thomas, Nisha Mary & Kashiramka, Smita & Yadav, Surendra Singh & Paul, Justin, 2022. "Role of emerging markets vis-à-vis frontier markets in improving portfolio diversification benefits," International Review of Economics & Finance, Elsevier, vol. 78(C), pages 95-121.
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    13. Gupta, R. & Donleavy, G.D., 2009. "Benefits of diversifying investments into emerging markets with time-varying correlations: An Australian perspective," Journal of Multinational Financial Management, Elsevier, vol. 19(2), pages 160-177, April.

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