International Asset Pricing and Portfolio Diversification with Time‐Varying Risk

Abstract

We test the conditional capital asset pricing model (CAPM) for the world's eight largest equity markets using a parsimonious generalized autoregressive conditional heteroskedasticity (GARCH) parameterization. Our methodology can be applied simultaneously to many assets and, at the same time, accommodate general dynamics of the conditional moments. The evidence supports most of the pricing restrictions of the model, but some of the variation in risk‐adjusted excess returns remains predictable during periods of high interest rates. Our estimates indicate that, although severe market declines are contagious, the expected gains from international diversification for a U.S. investor average 2.11 percent per year and have not significantly declined over the last two decades.

Business-cycle fluctuations and international equity correlations

“…Multivariate GARCH models have been an important modeling framework for many empirical studies of the dynamics of international stock returns (see, for example, DeSantis & Gerard, 1997;Karolyi & Stulz, 1996;Longin & Solnik, 1995). To set up a multivariate GARCH model, we assumed that the data-generating process of equity returns is given by the following equation:…”

Differences in the price of risk and the resulting response to shocks: an analysis of Asian markets

“…De Santis and Gerard (1997) use the former model to test the conditional version of CAPM for the world's eight largest equity markets covering the 1970-1994 period. They provide evidence that supports most pricing restrictions of the CAPM and find that benefits of diversification have not significantly declined over the last two decades.…”

“…This study investigates the impact of the recent changes in Asian financial markets on the benefits of international portfolio diversification and contagion following the methodology used by De Santis and Gerard (1997). First, a conditional version of the capital asset pricing model (CAPM) is tested using the data from four Asian emerging markets (Korea, Malaysia, Taiwan and Thailand) and three developed markets (Japan, the U.K., and the U.S.).…”

Home bias effect in the management literature

“…Risk minimisation in international investment and portfolio management models is based on diversification. The benefits of this approach have been widely studied and compared (Grubel 1968;De Santis and Gerard 1997). However, there is a large volume of literature that shows investors prefer putting their money into local companies looking abroad.…”