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International Portfolio Diversification Is Better Than You Think

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Do investors completely ignore the basics of portfolio theory? Given their over-exposure on domestic risk, investors should try to hedge this risk by picking foreign assets that have low correlation with their home assets. In the data though, we find a robust positive relationship between bilateral equity holdings and bilateral return correlations. We argue that this finding could be driven by the common impact of financial integration on cross-border equity holdings and on cross-market correlations. Indeed, when we instrument current correlations with past correlations to control for endogeneity, we recover asset demand functions that decrease with returns correlation.

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Paper provided by ESSEC Research Center, ESSEC Business School in its series ESSEC Working Papers with number DR 06013.

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Length: 30 pages
Date of creation: Oct 2006
Handle: RePEc:ebg:essewp:dr-06013
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ESSEC Research Center, BP 105, 95021 Cergy, France

Web page: http://www.essec.edu/
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