Advanced Search
MyIDEAS: Login to save this paper or follow this series

Is the International Diversification Potential Diminishing? Foreign Equity Inside and Outside the US

Contents:

Author Info

  • Karen K. Lewis
Registered author(s):

    Abstract

    Over the past two decades international markets have become more open, leading to a common perception that global capital markets have become more integrated. In this paper, I ask what this integration and its resulting higher correlation would imply about the diversification potential across countries. For this purpose, I examine two basic groups of international returns: (1) foreign market indices and (2) foreign stocks that are listed and traded in the US. I examine the first group since this is the standard approach in the international diversification literature, while I study the second group since some have argued that US-listed foreign stocks are the more natural diversification vehicle (Errunza et al (1999)). In order to consider the possibility of shifts in the covariance of returns over time, I extend the break-date estimation approach of Bai and Perron (1998) to test for and estimate possible break dates across returns along with their confidence intervals. I find that the covariances among country stock markets have indeed shifted over time for a majority of the countries. But in contrast to the common perception that markets have become significantly more integrated over time, the covariance between foreign markets and the US market have increased only slightly from the beginning to the end of the last twenty years. At the same time, the foreign stocks in the US markets have become significantly more correlated with the US market. To consider the economic significance of these parameter changes, I use the estimates to examine the implications for a simple portfolio decision model in which a US investor could choose between US and foreign portfolios. When restricted to holding foreign assets in the form of market indices, I find that the optimal allocation in foreign market indices actually increases over time. However, the optimal allocation into foreign stocks decreases when the investor is allowed to hold foreign stocks that are traded in the US. Also, the minimum variance attainable by the foreign portfolios has increased over time. These results suggest that the benefits to diversification have declined both for stocks inside and outside the US.

    Download Info

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
    File URL: http://www.nber.org/papers/w12697.pdf
    Download Restriction: no

    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12697.

    as in new window
    Length:
    Date of creation: Nov 2006
    Date of revision:
    Handle: RePEc:nbr:nberwo:12697

    Note: AP IFM
    Contact details of provider:
    Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
    Phone: 617-868-3900
    Email:
    Web page: http://www.nber.org
    More information through EDIRC

    Related research

    Keywords:

    Find related papers by JEL classification:

    This paper has been announced in the following NEP Reports:

    References

    References listed on IDEAS
    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
    as in new window
    1. Lubos Pástor, 2000. "Portfolio Selection and Asset Pricing Models," Journal of Finance, American Finance Association, American Finance Association, vol. 55(1), pages 179-223, 02.
    2. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 28(1), pages 3-24, August.
    3. Vihang Errunza & Ked Hogan & Mao-Wei Hung, 1999. "Can the Gains from International Diversification Be Achieved without Trading Abroad?," Journal of Finance, American Finance Association, American Finance Association, vol. 54(6), pages 2075-2107, December.
    4. Dumas, Bernard & Solnik, Bruno, 1995. " The World Price of Foreign Exchange Risk," Journal of Finance, American Finance Association, American Finance Association, vol. 50(2), pages 445-79, June.
    5. Vassalou, Maria, 2000. "Exchange rate and foreign inflation risk premiums in global equity returns," Journal of International Money and Finance, Elsevier, Elsevier, vol. 19(3), pages 433-470, June.
    6. Gehrig, Thomas, 1993. " An Information Based Explanation of the Domestic Bias in International Equity Investment," Scandinavian Journal of Economics, Wiley Blackwell, Wiley Blackwell, vol. 95(1), pages 97-109.
    7. G. Andrew Karolyi, 2006. "The World of Cross-Listings and Cross-Listings of the World: Challenging Conventional Wisdom," Review of Finance, European Finance Association, European Finance Association, vol. 10(1), pages 99-152.
    8. Geert Bekaert & Campbell R. Harvey & Robin L. Lumsdaine, 1998. "Dating the Integration of World Equity Markets," NBER Working Papers 6724, National Bureau of Economic Research, Inc.
    9. Maurice Obstfeld, 1992. "Risk-Taking, Global Diversification, and Growth," NBER Working Papers 4093, National Bureau of Economic Research, Inc.
    10. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, Econometric Society, vol. 48(4), pages 817-38, May.
    11. Bekaert, Geert & Harvey, Campbell R, 1995. " Time-Varying World Market Integration," Journal of Finance, American Finance Association, American Finance Association, vol. 50(2), pages 403-44, June.
    12. Baxter, Marianne & Crucini, Mario J, 1995. "Business Cycles and the Asset Structure of Foreign Trade," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(4), pages 821-54, November.
    13. Vassalou, Maria, 2000. "Exchange Rate And Foreign Inflation Risk Premiums In Global Equity Returns," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2448, C.E.P.R. Discussion Papers.
    14. Ferson, Wayne E & Harvey, Campbell R, 1993. "The Risk and Predictability of International Equity Returns," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 6(3), pages 527-66.
    15. Bekaert, Geert & Hodrick, Robert J, 1992. " Characterizing Predictable Components in Excess Returns on Equity and Foreign Exchange Markets," Journal of Finance, American Finance Association, American Finance Association, vol. 47(2), pages 467-509, June.
    16. Carrieri, Francesca & Errunza, Vihang & Sarkissian, Sergei, 2006. "The Dynamics of Geographic versus Sectoral Diversification: Is There a Link to the Real Economy?," Working Papers, University of Pennsylvania, Wharton School, Weiss Center 06-4, University of Pennsylvania, Wharton School, Weiss Center.
    17. Backus, David K & Kehoe, Patrick J & Kydland, Finn E, 1992. "International Real Business Cycles," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 100(4), pages 745-75, August.
    18. Doidge, Craig & Karolyi, G. Andrew & Stulz, Rene M., 2004. "Why are foreign firms listed in the U.S. worth more?," Journal of Financial Economics, Elsevier, Elsevier, vol. 71(2), pages 205-238, February.
    19. Alan C. Stockman & Linda L. Tesar, 1991. "Tastes and technology in a two-country model of the business cycle: explaining international co-movements," Working Paper 9019, Federal Reserve Bank of Cleveland.
    20. Chari, Anusha & Henry, Peter B., 2002. "Risk Sharing and Asset Prices: Evidence from a Natural Experiment," Research Papers, Stanford University, Graduate School of Business 1736r, Stanford University, Graduate School of Business.
    21. Baele, L., 2003. "Volatility Spillover Effects in European Equity Markets," Discussion Paper, Tilburg University, Center for Economic Research 2003-114, Tilburg University, Center for Economic Research.
    22. Perron, P. & Bai, J., 1995. "Estimating and Testing Linear Models with Multiple Structural Changes," Cahiers de recherche, Centre interuniversitaire de recherche en économie quantitative, CIREQ 9552, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
    23. Geert Bekaert & Campbell R. Harvey, 1997. "Foreign Speculators and Emerging Equity Markets," NBER Working Papers 6312, National Bureau of Economic Research, Inc.
    24. Peter Blair Henry, 2003. "Capital-Account Liberalization, the Cost of Capital, and Economic Growth," American Economic Review, American Economic Association, American Economic Association, vol. 93(2), pages 91-96, May.
    25. Adler, Michael & Dumas, Bernard, 1983. " International Portfolio Choice and Corporation Finance: A Synthesis," Journal of Finance, American Finance Association, American Finance Association, vol. 38(3), pages 925-84, June.
    26. Karen K. Lewis, 1999. "Trying to Explain Home Bias in Equities and Consumption," Journal of Economic Literature, American Economic Association, vol. 37(2), pages 571-608, June.
    27. Bekaert, Geert & Harvey, Campbell R., 1997. "Emerging equity market volatility," Journal of Financial Economics, Elsevier, Elsevier, vol. 43(1), pages 29-77, January.
    28. repec:kap:eurfin:v:10:y:2006:i:1:p:99-152 is not listed on IDEAS
    29. Bonser-Neal, Catherine, et al, 1990. " International Investment Restrictions and Closed-End Country Fund Prices," Journal of Finance, American Finance Association, American Finance Association, vol. 45(2), pages 523-47, June.
    30. Jushan Bai & Pierre Perron, 2003. "Critical values for multiple structural change tests," Econometrics Journal, Royal Economic Society, Royal Economic Society, vol. 6(1), pages 72-78, 06.
    31. BAI, Jushan & PERRON, Pierre, 1998. "Computation and Analysis of Multiple Structural-Change Models," Cahiers de recherche, Universite de Montreal, Departement de sciences economiques 9807, Universite de Montreal, Departement de sciences economiques.
    32. Kenneth R. French & James M. Poterba, 1991. "Investor Diversification and International Equity Markets," NBER Working Papers 3609, National Bureau of Economic Research, Inc.
    33. Peter Blair Henry, 2000. "Stock Market Liberalization, Economic Reform, and Emerging Market Equity Prices," Journal of Finance, American Finance Association, American Finance Association, vol. 55(2), pages 529-564, 04.
    34. Pesenti, Paolo & van Wincoop, Eric, 2002. "Can Nontradables Generate Substantial Home Bias?," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 34(1), pages 25-50, February.
    35. Stephen R. Foerster & G. Andrew Karolyi, 1999. "The Effects of Market Segmentation and Investor Recognition on Asset Prices: Evidence from Foreign Stocks Listing in the United States," Journal of Finance, American Finance Association, American Finance Association, vol. 54(3), pages 981-1013, 06.
    36. Tesar, Linda L. & Werner, Ingrid M., 1995. "Home bias and high turnover," Journal of International Money and Finance, Elsevier, Elsevier, vol. 14(4), pages 467-492, August.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as in new window

    Cited by:
    1. Arghyrou, Michael G & Gregoriou, Andros & Kontonikas, Alexandros, 2007. "Do real interest rates converge? Evidence from the European Union," Cardiff Economics Working Papers E2007/26, Cardiff University, Cardiff Business School, Economics Section.
    2. Quinn, Dennis & Voth, Hans-Joachim, 2008. "Free Flows, Limited Diversification: Explaining the Fall and Rise of Stock Market Correlations, 1890-2001," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7013, C.E.P.R. Discussion Papers.
    3. Dennis Quinn & Joachim Voth, 2006. "A century of global equity market correlations," Economics Working Papers, Department of Economics and Business, Universitat Pompeu Fabra 1119, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2008.
    4. Chi-Hsiou Hung, 2007. "Return Explanatory Ability and Predictability of Non-Linear Market Models," Working Papers 2007_05, Durham University Business School.

    Lists

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    Statistics

    Access and download statistics

    Corrections

    When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:12697. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ().

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.