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Small Caps in International Equity Portfolios: The Effects of Variance Risk

Giovanna Nicodano

University of Turin - Department of Economics and Statistics; Collegio Carlo Alberto

Massimo Guidolin

Bocconi University - Department of Finance

December 2005

AFA 2006 Boston Meetings Paper

We show that predictable covariances between means and variances of stock returns may have a first order effect on portfolio composition. In an international asset menu that includes both European and North American small capitalization equity indices, we find that a three-state, heteroskedastic regime switching VAR model is required to provide a good fit to weekly return data and to accurately predict the dynamics in the joint density of returns. As a result of the non-linear dynamic features revealed by the data, small cap portfolios become riskier in bear markets, i.e. display negative co-skewness with other stock indices. Because of this property, a power utility investor ought to hold a well diversified portfolio, despite the high risk premium and Sharpe ratios offered by small capitalization stocks. On the contrary small caps command large optimal weights when the investor ignores variance risk, by incorrectly assuming joint normality of returns. These results provide the missing partial equilibrium rationale for the presence of co skewness in the empirical asset pricing models that have been proposed to explain the cross-section of stock returns.

Number of Pages in PDF File: 54

Keywords: intertemporal portfolio choice, return predictability, co-skewness and co-kurtosis, international portfolio diversification

JEL Classification: G11, G15, F30, C32

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Date posted: March 19, 2005  

Suggested Citation

Nicodano, Giovanna and Guidolin, Massimo, Small Caps in International Equity Portfolios: The Effects of Variance Risk (December 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=870292 or http://dx.doi.org/10.2139/ssrn.870292

Contact Information

Giovanna Nicodano
University of Turin - Department of Economics and Statistics ( email )
Turin, 10134
HOME PAGE: http://www.carloalberto.org/people/faculty/fellows/nicodano/
Collegio Carlo Alberto ( email )
via Real Collegio 30
Moncalieri, Torino 10024
390116705006 (Phone)
HOME PAGE: http://www.carloalberto.org/people/nicodano/
Massimo Guidolin (Contact Author)
Bocconi University - Department of Finance ( email )
Via Roentgen 1
Milano, MI 20136
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