Is the Potential for International Diversification Disappearing?
University of Toronto - Rotman School of Management; Copenhagen Business School; University of Aarhus - CREATES
Vihang R. Errunza
McGill University - Desautels Faculty of Management
University of Houston - C.T. Bauer College of Business
Central Bank of Luxembourg
March 16, 2010
Since understanding and quantifying the evolution of security co-movements is critical for asset pricing and portfolio allocation, we investigate patterns and trends in correlations over time using weekly returns for large systems of developed markets (DMs) and emerging markets (EMs) during the period 1973-2009. We use the DECO, DCC, and BEKK correlation models, and develop a novel dynamic t-copula which generalizes the normal copula, to allow for dynamic tail dependence. We demonstrate that it is possible to overcome the well known dimensionality problems and compute correlation and tail dependence in international markets using large samples, without relying on factor models. Our results suggest that correlations have been significantly trending upward for both the DMs and EMs. Further, the evidence clearly contradicts the decoupling hypothesis. Although the tail dependence is increasing through time for both EMs and DMs, the level of the tail dependence is still very low at the end of our sample period for EMs as compared to DMs. Therefore, while the correlation analysis suggests that the diversification potential of EMs has largely disappeared, this is contradicted by our findings on tail dependence. Thus, even though diversification benefits might have lessened in the case of DMs, the case for EMs remains intact.
Number of Pages in PDF File: 41
Keywords: international asset pricing, asset allocation, dynamic conditional correlation (DCC), dynamic equicorrelation (DECO), dynamic copula
JEL Classification: G15
Date posted: March 21, 2010