Abstract
The viability of international diversification involves balancing benefits and costs. This balance hinges on the degree of asset dependence. In light of theoretical research linking diversification and dependence, we examine international diversification using two measures of dependence: correlations and copulas. We document several findings. First, dependence has increased over time. Second, we find evidence of asymmetric dependence or downside risk in Latin America, but less in the G5. The results indicate very little downside risk in East Asia. Third, East Asian and Latin American returns exhibit some correlation complexity. Interestingly, the regions with maximal dependence or worst diversification do not command large returns. Our results suggest international limits to diversification. They are also consistent with a possible tradeoff between international diversification and systemic risk.
1. Introduction
The net benefit of international diversification is of great importance in today’s economic climate. In general, the tradeoff between diversification’s benefits and costs hinges on the degree of dependence across securities, as observed by Samuelson (1967), Ibragimov et al. (2009b), Shin (2009), Veldkamp and Van Nieuwerburgh (2010), and Bai and Green (2010), among others. Economists and investors often assess diversification benefits using a measure of dependence, such as correlation.1 It is therefore vital to have accurate measures of dependence. There are several measures available in finance, including the traditional correlation and copulas. While each approach has advantages and disadvantages, researchers have rarely compared them in the same empirical study.2 Such reliance on one dependence measure prevents easy assessment of the degree of international diversification opportunities, and how they differ over time or across regions.
6. Conclusions
Diversification carries benefits and costs, as noted by a growing body of theoretical literature. Although diversification is measured by dependence when marginals are fixed, few studies compare asset dependence using robust dependence measures. Moreover, when assets have heavy tails, diversification may not be optimal, and individually optimal diversification may differ from social optimality since investors undervalue systemic risk. These observations motivate our empirical study. We examine diversification opportunities in international markets, using two different dependence measures, correlations and copulas.
