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Time-varying risk and international portfolio diversification with contagious bear markets

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  • Giorgio De Santis
  • Bruno Gerard

Abstract

In this paper we estimate and test a conditional version of the international CAPM. By using a parsimonious parameterization recently proposed by Ding and Engle (1994), we allow risk premia, betas, and correlations to very through time and test the cross-section restrictions of the model using a relatively large number of assets. One advantage of our test is that it does not require the market weights to be observed in each period. In support of the international CAPM, we find that world-wide risk is priced whereas country-specific risk is not. Further, we find that the price of world risk is time-varying and has a strong January seasonal. When the price of risk is allowed to vary, a January dummy and the world dividend yield are driven out as independently priced factors. However, contrary to the prediction of the model, differences in risk premia across countries are explained not only by world-wide risk, but also by a constant country-specific factor. The estimated correlations reveal three main facts, cross-country correlations vary through time; they have been affected only to a limited extent by the process of liberalization of the last decade; they tend to increase during severe bear markets in the U.S. However, international correlations are smaller than correlations among U.S. assets. Therefore, investors gain from global diversification, even with contagious bear markets.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Minneapolis in its series Discussion Paper / Institute for Empirical Macroeconomics with number 99.

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Date of creation: 1995
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Handle: RePEc:fip:fedmem:99

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Keywords: Capital assets pricing model ; International finance ; Investments;

References

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  1. Bollerslev, Tim & Engle, Robert F & Wooldridge, Jeffrey M, 1988. "A Capital Asset Pricing Model with Time-Varying Covariances," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 116-31, February.
  2. Ferson, Wayne E & Harvey, Campbell R, 1993. "The Risk and Predictability of International Equity Returns," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 527-66.
  3. Campbell, John, 1993. "Intertemporal Asset Pricing Without Consumption Data," Scholarly Articles 3221491, Harvard University Department of Economics.
  4. Engel, Charles & Rodrigues, Anthony P, 1989. "Tests of International CAPM with Time-Varying Covariances," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 4(2), pages 119-38, April-Jun.
  5. Bollerslev, Tim, 1986. "Generalized autoregressive conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 31(3), pages 307-327, April.
  6. Cumby, Robert E & Glen, Jack D, 1990. " Evaluating the Performance of International Mutual Funds," Journal of Finance, American Finance Association, vol. 45(2), pages 497-521, June.
  7. K.C. Chan & G. Andrew Karolyi & Rene M. Stulz, 1992. "Global Financial Markets and the Risk Premium on U.S. Equity," NBER Working Papers 4074, National Bureau of Economic Research, Inc.
  8. Giovannini, Alberto & Jorion, Philippe, 1989. " The Time Variation of Risk and Return in the Foreign Exchange and Stock Markets," Journal of Finance, American Finance Association, vol. 44(2), pages 307-25, June.
  9. Engle, Robert F & Lilien, David M & Robins, Russell P, 1987. "Estimating Time Varying Risk Premia in the Term Structure: The Arch-M Model," Econometrica, Econometric Society, vol. 55(2), pages 391-407, March.
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Cited by:
  1. Karolyi, G Andrew & Stulz, Rene M, 1996. " Why Do Markets Move Together? An Investigation of U.S.-Japan Stock Return Comovements," Journal of Finance, American Finance Association, vol. 51(3), pages 951-86, July.
  2. G. Andrew Karolyi & Rene Stulz, . "Why do Markets Move Together? An Investigation of U.S.-Japan Stock Return Comovements using ADRS," Research in Financial Economics 9501, Ohio State University.

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