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International portfolio choice under multi-factor stochastic volatility

Author

Listed:
  • Marcos Escobar-Anel
  • Sebastian Ferrando
  • Christoph Gschnaidtner
  • Alexey Rubtsov

Abstract

In this article, we develop an identifiable multi-factor stochastic volatility model for international portfolio choice problems in complete and incomplete markets. Allowing for stochastic covariance between financial asset returns and foreign exchange rates, optimal investment strategies are derived in closed form and welfare losses arising from suboptimal investment strategies are analysed. Moreover, we provide a two-step procedure for estimating as well as calibrating the model parameters and use this ansatz to illustrate optimal investment decisions for the S&P 500, the German blue chip index DAX, and the USD/EUR foreign exchange rate. We find, both theoretically and empirically, that the model satisfies various well-known stylized facts of equity and foreign exchange rate markets and that investors who invest myopically or ignore derivative assets can incur substantial welfare losses implying strong evidence for significant welfare benefits from international diversification across different asset classes.

Suggested Citation

  • Marcos Escobar-Anel & Sebastian Ferrando & Christoph Gschnaidtner & Alexey Rubtsov, 2022. "International portfolio choice under multi-factor stochastic volatility," Quantitative Finance, Taylor & Francis Journals, vol. 22(6), pages 1193-1216, June.
    • Handle: RePEc:taf:quantf:v:22:y:2022:i:6:p:1193-1216
    DOI: 10.1080/14697688.2021.2019820
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