Small caps in international equity portfolios: the effects of variance risk

Massimo Guidolin and Giovanna Nicodano

No 2005-075, Working Papers from Federal Reserve Bank of St. Louis

Abstract: 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.

Keywords: Investments; Foreign (search for similar items in EconPapers)
Date: 2007
New Economics Papers: this item is included in nep-fin, nep-fmk, nep-rmg and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

Published in Annals of Finance, January 2009, 5(1), pp. 15-48

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Related works:
Journal Article: Small caps in international equity portfolios: the effects of variance risk (2009)
Working Paper: Small Caps in International Equity Portfolios: The Effects of Variance Risk (2005)
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DOI: 10.20955/wp.2005.075

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