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An Economic Measure of Diversification Benefits

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  • Lingfeng Li

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.

Suggested Citation

  • Lingfeng Li, 2003. "An Economic Measure of Diversification Benefits," Yale School of Management Working Papers ysm371, Yale School of Management, revised 01 Jul 2003.
    • Handle: RePEc:ysm:wpaper:ysm371
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    References listed on IDEAS

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