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Time-varying risk and international portfolio diversification with contagious bear markets

  • Giorgio De Santis
  • Bruno Gerard

In this paper we estimate and test a conditional version of the international CAPM. By using a parsimonious parameterization recently proposed by Ding and Engle (1994), we allow risk premia, betas, and correlations to very through time and test the cross-section restrictions of the model using a relatively large number of assets. One advantage of our test is that it does not require the market weights to be observed in each period. In support of the international CAPM, we find that world-wide risk is priced whereas country-specific risk is not. Further, we find that the price of world risk is time-varying and has a strong January seasonal. When the price of risk is allowed to vary, a January dummy and the world dividend yield are driven out as independently priced factors. However, contrary to the prediction of the model, differences in risk premia across countries are explained not only by world-wide risk, but also by a constant country-specific factor. The estimated correlations reveal three main facts, cross-country correlations vary through time; they have been affected only to a limited extent by the process of liberalization of the last decade; they tend to increase during severe bear markets in the U.S. However, international correlations are smaller than correlations among U.S. assets. Therefore, investors gain from global diversification, even with contagious bear markets.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Discussion Paper / Institute for Empirical Macroeconomics with number 99.

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Date of creation: 1995
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Handle: RePEc:fip:fedmem:99
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  1. Engle, Robert F & Lilien, David M & Robins, Russell P, 1987. "Estimating Time Varying Risk Premia in the Term Structure: The Arch-M Model," Econometrica, Econometric Society, vol. 55(2), pages 391-407, March.
  2. Chan, K. C. & Karolyi, G. Andrew & Stulz, ReneM., 1992. "Global financial markets and the risk premium on U.S. equity," Journal of Financial Economics, Elsevier, vol. 32(2), pages 137-167, October.
  3. Cumby, Robert E & Glen, Jack D, 1990. " Evaluating the Performance of International Mutual Funds," Journal of Finance, American Finance Association, vol. 45(2), pages 497-521, June.
  4. Campbell, John, 1993. "Intertemporal Asset Pricing Without Consumption Data," Scholarly Articles 3221491, Harvard University Department of Economics.
  5. Bollerslev, Tim & Engle, Robert F & Wooldridge, Jeffrey M, 1988. "A Capital Asset Pricing Model with Time-Varying Covariances," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 116-31, February.
  6. Charles Engel & Anthony P. Rodrigues, 1987. "Tests of International CAPM with Time-Varying Covariances," NBER Working Papers 2303, National Bureau of Economic Research, Inc.
  7. Tim Bollerslev, 1986. "Generalized autoregressive conditional heteroskedasticity," EERI Research Paper Series EERI RP 1986/01, Economics and Econometrics Research Institute (EERI), Brussels.
  8. Alberto Giovannini & Philippe Jorion, 1988. "The Time-Variation of Risk and Return in the Foreign Exchange and Stock Markets," NBER Working Papers 2573, National Bureau of Economic Research, Inc.
  9. Ferson, Wayne E & Harvey, Campbell R, 1993. "The Risk and Predictability of International Equity Returns," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 527-66.
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