International Portfolio Diversification and Multilateral Effects of Correlations

53 Pages Posted: 10 Mar 2012 Last revised: 6 Jun 2022

See all articles by Paul R. Bergin

Paul R. Bergin

University of California, Davis - Department of Economics; National Bureau of Economic Research (NBER)

Ju Hyun Pyun

Korea University Business School (KUBS)

Date Written: March 2012

Abstract

Not only are investors biased toward home assets, but when they do invest abroad, they appear to favor countries with returns more correlated with home assets. Often attributed to a preference for familiarity, this ‘correlation puzzle’ further reduces effective diversification. However, a multi-country DSGE model of portfolio choice makes clear that the effects of a bilateral stock return correlation must be studied in the context of the full covariance structure. For example, the attractiveness of a foreign country as a hedge depends upon its hedging potential relative to other potential destination countries. This paper develops a new empirical approach based upon a multi-country theoretical model that controls for the full covariance structure in a theoretically rigorous yet tractable manner. Estimation under this approach overturns the correlation puzzle, and finds that international investors do seek the diversification benefits of low cross-country correlations as theory would predict. Since covariances are central to modern theories of portfolio choice, this empirical methodology should be useful also for other applications.

Suggested Citation

Bergin, Paul R. and Pyun, Ju Hyun, International Portfolio Diversification and Multilateral Effects of Correlations (March 2012). NBER Working Paper No. w17907, Available at SSRN: https://ssrn.com/abstract=2019404

Paul R. Bergin (Contact Author)

University of California, Davis - Department of Economics ( email )

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Ju Hyun Pyun

Korea University Business School (KUBS) ( email )

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Korea, Republic of (South Korea)
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