Time-Variation in the International Diversification Benefits

Abstract:     
Does the economic value of internationally diversified portfolios shrink over time in an increasingly integrated global market? How do the dynamics of global economy and financial markets affect the benefits of international diversification? What is a proper measure of diversification benefits? In contrast to previous research, this paper specifically models the investment constraints associated with liquidity and portfolio feasibility. We find that, although the world market is more integrated, the time-varying benefits of global diversification remain positive. The addition of weighting bounds decreases a portion of diversification benefits, but this addition also decreases the uncertainty of gains and asset allocation and induces diversity in the diversified portfolio. Correlation is not associated with the potential diversification benefits but adjusted R-squared from a multifactor model is. Inflation risk, default risk premium, liquidity and size of equity market are associated with the diversification benefits.

Number of Pages in PDF File: 65

Keywords: Diversification Benefits; Investment Constraints, International Portfolio

JEL Classification: F36, G11, G15

working papers series