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Assessing the benefits of international portfolio diversification in bonds and stocks

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Author Info
Roberto A. De Santis () (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
Lucio Sarno () (Finance Group, Warwick Business School, University of Warwick, Coventry CV4 7AL, UK.)

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Abstract

This paper considers a stylized asset pricing model where the returns from exchange rates, stocks and bonds are linked by basic risk-arbitrage relationships. Employing GMM estimation and monthly data for 18 economies and the US (treated as the domestic country), we identify through a simple test the countries whose assets strongly comove with US assets and the countries whose assets might offer larger diversification benefits. We also show that the strengthening of the comovement of returns across countries is neither a gradual process nor a global phenomenon, reinforcing the case for international diversi.cation. However, our results suggest that fund managers are better of constructing portfolios selecting assets from a subset of countries than relying on either fully internationally diversified or purely domestic portfolios. JEL Classification: F31, G10.

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Paper provided by European Central Bank in its series Working Paper Series with number 883.

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Length: 45 pages
Date of creation: Mar 2008
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Handle: RePEc:ecb:ecbwps:20080883

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Keywords: Asset pricing; exchange rates; international parity conditions; market integration; stochastic discount factor.;

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