Working Paper: NBER ID: w17907
Authors: Paul R. Bergin; Ju Hyun Pyun
Abstract: Not only are investors biased toward home assets, but when they do invest abroad, they appear to favor countries with returns more correlated with home assets. Often attributed to a preference for familiarity, this ‘correlation puzzle’ further reduces effective diversification. However, a multi-country DSGE model of portfolio choice makes clear that the effects of a bilateral stock return correlation must be studied in the context of the full covariance structure. For example, the attractiveness of a foreign country as a hedge depends upon its hedging potential relative to other potential destination countries. This paper develops a new empirical approach based upon a multi-country theoretical model that controls for the full covariance structure in a theoretically rigorous yet tractable manner. Estimation under this approach overturns the correlation puzzle, and finds that international investors do seek the diversification benefits of low cross-country correlations as theory would predict. Since covariances are central to modern theories of portfolio choice, this empirical methodology should be useful also for other applications.
Keywords: international portfolio diversification; correlation puzzle; multicountry model; equity holdings
JEL Codes: F36; F41; G11; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher bilateral stock return correlation (C10) | lower bilateral equity asset holdings (G51) |
| inclusion of multilateral effects (F69) | reversal of initial correlation puzzle (C59) |
| foreign country as a hedge (G15) | influenced by hedging potential relative to other countries (F31) |
| third-country correlations (F29) | shaping bilateral asset holdings (F32) |