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An Economic Measure of Diversification Benefits

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  • Lingfeng Li
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    Abstract

    In this paper, we develop a utility based economic measure for diversification benefits, calculated as the maximum premium that an investor is willing to pay for holding a more diversified portfolio. The utility based economic measure allows one to evaluate the expansion of the investment opportunity set by combining the information in both risk and return properties. It also offers a flexible framework to examine how investors with different tolerances for risk may respond to the expansion of the investment opportunity set by combining the information in both risk and return properties. It also offers a flexible framework to examine how investors with different tolerances for risk may respond to the expansion of the investment opportunity set. This measure is contrasted with the results of mean-variance spanning tests. Empirical analysis shows that investors enjoy substantial diversification benefits by adding emerging stock markets and major bond markets to the existing portfolio of G7 stock markets. Investors' risk tolerance affects their evaluation of new assets. Short-sale constraints reduce, but do not eliminate, diversificaton benefits.

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    File URL: http://icfpub.som.yale.edu/publications/2459
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    Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm371.

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    Date of creation: 01 May 2003
    Date of revision: 01 Jul 2003
    Handle: RePEc:ysm:somwrk:ysm371
    Contact details of provider: Web page: http://icf.som.yale.edu/

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    Keywords: Measuring Diversification Benefits; Asset Allocation; Short Sale Constraint;

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    1. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-262, April.
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    8. William N. Goetzmann & Lingfeng Li & K. Geert Rouwenhorst, 2005. "Long-Term Global Market Correlations," The Journal of Business, University of Chicago Press, vol. 78(1), pages 1-38, January.
    9. Bekaert, Geert & Harvey, Campbell R, 1995. " Time-Varying World Market Integration," Journal of Finance, American Finance Association, vol. 50(2), pages 403-444, June.
    10. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942, April.
    11. Ferson, Wayne E & Foerster, Stephen R & Keim, Donald B, 1993. " General Tests of Latent Variable Models and Mean-Variance Spanning," Journal of Finance, American Finance Association, vol. 48(1), pages 131-156, March.
    12. Chen, Zhiwu & Knez, Peter J, 1995. "Measurement of Market Integration and Arbitrage," Review of Financial Studies, Society for Financial Studies, vol. 8(2), pages 287-325.
    13. Snow, Karl N, 1991. " Diagnosing Asset Pricing Models Using the Distribution of Asset Returns," Journal of Finance, American Finance Association, vol. 46(3), pages 955-983, July.
    14. Wang, Zhenyu, 1998. "Efficiency loss and constraints on portfolio holdings," Journal of Financial Economics, Elsevier, vol. 48(3), pages 359-375, June.
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    Cited by:

    1. Fletcher, Jonathan & Marshall, Andrew, 2005. "An empirical examination of the benefits of international diversification," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 15(5), pages 455-468, December.

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