Correlation Risk and International Portfolio Choice
53 Pages Posted: 8 Apr 2016
Date Written: April 6, 2016
We study the optimal portfolio choice of international investors when variances and correlations are stochastic. We assume that the returns from the perspective of the domestic investor are driven by a Wishart Affine Stochastic Correlation (WASC) model. We show that this also holds from the perspective of the foreign investor and give the relations between the variance-covariance matrices and the parameters of its dynamics in both currencies. Stochastic second moments have an impact on risk and returns that characterize the domestic and the foreign investment opportunity sets. Optimal portfolios and hedging demands of international investors differ due to their dependence on exchange rate variances and correlations. The benefits from investing can be different for domestic and foreign investors, and can also react differently to changes in second moments. These findings hold both in complete and incomplete markets.
Keywords: International asset allocation, stochastic correlation, Wishart process, intertemporal hedging demand, diversification benefits
JEL Classification: G11, G13
Suggested Citation: Suggested Citation