International Portfolio Diversification and Multilateral Effects of Correlations

Paul Bergin and Ju Hyun Pyun

No 17907, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: F36 F41 G11 G15 (search for similar items in EconPapers)
Date: 2012-03
New Economics Papers: this item is included in nep-ifn and nep-opm
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Citations: View citations in EconPapers (2)

Published as Bergin, Paul R. & Pyun, Ju Hyun, 2016. "International portfolio diversification and multilateral effects of correlations," Journal of International Money and Finance, Elsevier, vol. 62(C), pages 52-71.

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Journal Article: International portfolio diversification and multilateral effects of correlations (2016)
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