Optimal International Diversification: Theory and Practice from a Swiss Investor’s Perspective
This paper reviews some recent developments in the area of optimal international portfolio diversification and investigates important issues for future research. In the latest models proposed in the financial literature that generate optimal holdings over time, both the quantities of risks (measured by the covariances with various risk factors) and the prices of risk(risk premiums) are time varying. The former are generally specified by some ARCH process, whereas the latter are estimated using instruments such as dividend yield or bond premiums. Available methodologies and the choice of the instruments are discusses in general terms,as weel as the feasibility of active managemant with these models. I test a few of them by considering a Swiss investor who holds an internationally diversified portfolio including local stock indices, as well as an exposure to real estate, and wo may hedge some or all of his currency risk. the empirical tests are performed using a very intuitive and powerful non-parametric threshold ARCH specification to model time-varying sources of risk. Risk premiums are estimated using simple and widely available instruments in the form of macroeconomic variables, but also indicators used in technical analysis. Both the in-sample and the out-of-sample results suggest that the proposed nan-parametric approach is powerful and may constitute a valuable tool for international portfolio managers.
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