Assessing the Benefits of International Portfolio Diversification in Bonds and Stocks

45 Pages Posted: 1 Apr 2008

See all articles by Roberto A. De Santis

Roberto A. De Santis

European Central Bank (ECB) - Directorate General Economics

Lucio Sarno

City University London - Sir John Cass Business School; Centre for Economic Policy Research (CEPR)

Date Written: March 1, 2008

Abstract

This paper considers a stylized asset pricing model where the returns from exchange rates, stocks and bonds are linked by basic risk-arbitrage relationships. Employing GMM estimation and monthly data for 18 economies and the US (treated as the domestic country), we identify through a simple test the countries whose assets strongly comove with US assets and the countries whose assets might offer larger diversification benefits. We also show that the strengthening of the comovement of returns across countries is neither a gradual process nor a global phenomenon, reinforcing the case for international diversification. However, our results suggest that fund managers are better off constructing portfolios selecting assets from a subset of countries than relying on either fully internationally diversified or purely domestic portfolios.

Keywords: Asset pricing, exchange rates, international parity conditions, market integration, stochastic discount factor

JEL Classification: F31, G10

Suggested Citation

De Santis, Roberto A. and Sarno, Lucio, Assessing the Benefits of International Portfolio Diversification in Bonds and Stocks (March 1, 2008). ECB Working Paper No. 883. Available at SSRN: https://ssrn.com/abstract=1105383

Roberto A. De Santis (Contact Author)

European Central Bank (ECB) - Directorate General Economics ( email )

Kaiserstrasse 29
D-60311 Frankfurt am Main
Germany

Lucio Sarno

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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