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An Economic Measure of Diversification Benefits

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  • Lingfeng Li
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    Abstract

    In this paper, we develop a utility based economic measure for diversification benefits, calculated as the maximum premium that an investor is willing to pay for holding a more diversified portfolio. The utility based economic measure allows one to evaluate the expansion of the investment opportunity set by combining the information in both risk and return properties. It also offers a flexible framework to examine how investors with different tolerances for risk may respond to the expansion of the investment opportunity set by combining the information in both risk and return properties. It also offers a flexible framework to examine how investors with different tolerances for risk may respond to the expansion of the investment opportunity set. This measure is contrasted with the results of mean-variance spanning tests. Empirical analysis shows that investors enjoy substantial diversification benefits by adding emerging stock markets and major bond markets to the existing portfolio of G7 stock markets. Investors' risk tolerance affects their evaluation of new assets. Short-sale constraints reduce, but do not eliminate, diversificaton benefits.

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    Bibliographic Info

    Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm371.

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    Date of creation: 01 May 2003
    Date of revision: 01 Jul 2003
    Handle: RePEc:ysm:somwrk:ysm371

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    Keywords: Measuring Diversification Benefits; Asset Allocation; Short Sale Constraint;

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    References

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    1. Wang, Zhenyu, 1998. "Efficiency loss and constraints on portfolio holdings," Journal of Financial Economics, Elsevier, vol. 48(3), pages 359-375, June.
    2. William Goetzmann & Lingfeng Li & K. Rouwenhorst, 2001. "Long-Term Global Market Correlations," Yale School of Management Working Papers ysm237, Yale School of Management, revised 01 Jan 2008.
    3. Raymond Kan & Guofu Zhou, 2012. "Tests of Mean-Variance Spanning," Annals of Economics and Finance, Society for AEF, vol. 13(1), pages 139-187, May.
    4. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of security market data for models of dynamic economies," Discussion Paper / Institute for Empirical Macroeconomics 29, Federal Reserve Bank of Minneapolis.
    5. Sharpe, William F., 1990. "Capital Asset Prices With and Without Negative Holding," Nobel Prize in Economics documents 1990-3, Nobel Prize Committee.
    6. Luboš Pástor & Robert F. Stambaugh, 1999. "Comparing Asset Pricing Models: An Investment Perspective," CRSP working papers 497, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    7. Huberman, Gur & Kandel, Shmuel, 1987. " Mean-Variance Spanning," Journal of Finance, American Finance Association, vol. 42(4), pages 873-88, September.
    8. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942.
    9. Harvey, Campbell R, 1995. "Predictable Risk and Returns in Emerging Markets," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 773-816.
    10. Chen, Zhiwu & Knez, Peter J, 1995. "Measurement of Market Integration and Arbitrage," Review of Financial Studies, Society for Financial Studies, vol. 8(2), pages 287-325.
    11. Ferson, Wayne E & Foerster, Stephen R & Keim, Donald B, 1993. " General Tests of Latent Variable Models and Mean-Variance Spanning," Journal of Finance, American Finance Association, vol. 48(1), pages 131-56, March.
    12. Geert Bekaert & Campbell R. Harvey, 1994. "Time-Varying World Market Integration," NBER Working Papers 4843, National Bureau of Economic Research, Inc.
    13. Snow, Karl N, 1991. " Diagnosing Asset Pricing Models Using the Distribution of Asset Returns," Journal of Finance, American Finance Association, vol. 46(3), pages 955-83, July.
    14. Baxter, Marianne & Jermann, Urban J, 1997. "The International Diversification Puzzle Is Worse Than You Think," American Economic Review, American Economic Association, vol. 87(1), pages 170-80, March.
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    Cited by:
    1. Fletcher, Jonathan & Marshall, Andrew, 2005. "An empirical examination of the benefits of international diversification," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 15(5), pages 455-468, December.

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