NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

International Portfolio Diversification and Multilateral Effects of Correlations

Paul R. Bergin, Ju Hyun Pyun

NBER Working Paper No. 17907
Issued in March 2012
NBER Program(s):   IFM

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.

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This paper was revised on December 8, 2014

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Document Object Identifier (DOI): 10.3386/w17907

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