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International Asset Allocation with Time-Varying Correlations

  • Andrew Ang
  • Geert Bekaert

It is widely believed that correlations between international equity markets tend to increase in highly volatile bear markets. This has led some to doubt the benefits of international diversification. This article solves the dynamic portfolio choice problem of a US investor faced with a time-varying investment opportunity set which may be characterized by correlations and volatilities that increase in bad times. We model the state dependance of US, UK, and German equity returns using a regime-switching model and find evidence for the existence of a high volatility regime, in which returns are more highly correlated and have lower means. Solving the dynamic asset allocation problem for a CCRA investor, we show international diversification is still valuable with regime changes. Currency hedging imparts further benefit. The costs of ignoring the regimes are small for moderate levels of risk aversion, and the intertemporal hedging demands induced by time-varying correlations are negligible.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7056.

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Date of creation: Mar 1999
Date of revision:
Publication status: published as Ang, A. and G. Bekaert. "International Asset Allocation With Regime Shifts," Review of Financial Studies, 2002, v15(4), 1137-1187.
Handle: RePEc:nbr:nberwo:7056
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  1. Andrew Ang & Geert Bekaert, 1998. "Regime Switches in Interest Rates," NBER Working Papers 6508, National Bureau of Economic Research, Inc.
  2. Balduzzi, Pierluigi & Lynch, Anthony W., 1999. "Transaction costs and predictability: some utility cost calculations," Journal of Financial Economics, Elsevier, vol. 52(1), pages 47-78, April.
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