Working Paper: NBER ID: w7056
Authors: Andrew Ang; Geert Bekaert
Abstract: 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.
Keywords: No keywords provided
JEL Codes: C12; C13; C32; E32; F30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high volatility regime (C58) | higher correlations (C10) |
| high volatility regime (C58) | lower means (E30) |
| higher correlations (C10) | impacting perceived benefits of diversification (F69) |
| high volatility regime (C58) | costs associated with ignoring regime changes are small for moderate levels of risk aversion (D81) |
| time-varying correlations (C22) | negligible intertemporal hedging demands (D15) |
| ignoring periods of high correlations (C10) | utility cost of not being internationally diversified (F69) |