Regime Switching, Asymmetric Correlation and International Portfolio Choices
20 Pages Posted: 10 Mar 2010
Date Written: January 2010
The aim of this paper is to investigate the behavior of international equity returns and correlations using the discrete-time Markov-switching model and the impact of this behavior on international portfolio choices. We take the perspective of a US-based global investor who considers investment across the six largest major markets over the period from December 1994 to July 2009. Results show that financial markets are characterized by two regimes: a bull and a bear markets. Besides, correlations appear to be very important in a bear state and significantly different than those in bull market. Finally, optimal portfolio weights vary considerably across regimes and over time as investors revise their estimates of the state probabilities. For a degree of risk aversion equal to three, the optimal weight of domestic asset is equal to 100% in a bear regime. Thus, the presence of regime in the equity return distributions turns out to play important roles in the U.S. investors’ international portfolio choices. Therefore, it helps to explain the home equity bias.
Keywords: Markov regime switching, asymmetric correlation, portfolio optimization, international portfolio choices
JEL Classification: F3, G11, G15
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