Download Time-varying diversification benefits

JEM044 - International Finance
December 15, 2015
International portfolio diversification benefits:
Cross-country evidence from a local
perspective
Authors of the Paper:
Joost Driessen
Luc Laeven
Presented by:
Osaid Hashmi
Tianqi Wang
Lucie Wdowyczynová
Contents




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Introduction
Measuring international diversification benefits
Empirical results on international diversification
benefits
Explaining the cross-country variation in
diversification benefits
Time-varying diversification benefits
Conclusions
 Introduction
Osaid Hashmi
Research Questions



Does international portfolio diversification benefit
a local investor?
How does it differ across country and how has it
changed over time?
Investors from which area benefit the most from
investing abroad?
Market observations



Investors from the developing countries benefit the
most from investing abroad
The larger the country risk, the greater the gain
Diversification varies over time as country risk
changes
Analysis



Institutional investors in small countries can make
large profits if freed of the restrictions
Benefits for markets such as the United States are
smaller compared to others
The Paper:
i.
ii.
Measures potential international diversification benefits for a
large number of countries
Analyzes cross-country differences in these benefits
Analysis approach used



The economic size of the diversification is used
Cross-country and time series variation in benefits
is explained using financial and macro-economic
variables
Paper is an extension to the research of
i.
ii.
iii.
iv.
Huberman and Kandel (1987)
Bekaert and Urias (1996)
DNW (2001)
Li et al. (2003)
All these are
about an investor
from the US
Analysis approach used (cont.)

Two types of diversifications have been examined
i.
Regional Diversification Benefits
(Investment in the regional equity index)
ii. Global Diversification Benefits
(Investment in markets of Europe, US and Far East)


Market Data: 52 countries, 1985 – 2002 (monthly)
Regression Framework: Developed by Huberman
and Kandel (1987) and DNW (2001)
Empirical Analysis

Calculation of economic size of the diversification
benefits:
 Improvement
in Sharpe ratios
 Increase in expected returns

Cases used:
 Frictionless
markets
 Markets with short-sales constraints
Empirical Results

In case of no short-sales constraints
 Economically
large and statistically significant benefits
for investors in almost all countries
 Sharpe ratios increase from 10% to 21%
 Global diversification shows greater benefits
compared to regional diversification
Empirical Results (cont.)

In case of short-sales constraints
 No
significant difference as compared to that of
without short-sales constraints
 Sharpe ratio increases from 10% to 18% when
allowing for global diversification
 No significant benefits observed for US investors
 Developing countries display high gains
 Measuring international diversification benefits
Osaid Hashmi
Measuring the benefits

Standard mean-variance framework of Markowitz
(1952)
Diversification – A
 Global Diversification – B
 Regional


Does the risk-return tradeoff improve by adding
asset set A or B?
We analyze Statistical Significance and Economic
Significance
Statistical Signifance


Regression Framework: Developed by Huberman and
Kandel (1987) , DNW (2001), De Roon and Nijman
(2001)
Adding N new assets to a given K benchmark of assets

K benchmark assets: Domestic index


K=1
N assets: Asset sets A (Regional) or B (Global)

N = 1 (for A) , N = 3 (for B)
rt+1 = a + bRt+1 + et+1
Statistical Significance (cont.)
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

Frictionless markets:
rt+1 = a + bRt+1 + et+1
rt+1 = N-dimensional column vector with the N returns
on the additional assets
Rt+1 = K-dimensional return vector for the K
benchmark assets
a = N-dimensional constant term
b = N by K matrix with slope coefficients
et+1 = N-dimensional vector with zero-expectation error
terms
Statistical Significance (cont.)



rt+1 = a + bRt+1 + et+1
Null hypothesis: K benchmark assets span the
entire market of all K + N assets
a = 0, blK = lN
Spanning test tests whether local stock market
index spans a portfolio that includes asset set A or
asset set B
No information on a risk-free rate needed
Statistical Significance (cont.)

Markets with short-selling constraints
 17-years
monthly data used to minimize small sample
problems
 Short-sales constraints on only one asset (country’s
local index)
 Small sample properties of the spanning test depend on
number of short-sale restrictions
Economic Significance

Measured in two ways:
 Increase
in Sharpe ratio when adding new N assets to
the K benchmark assets
 Increase in expected return when adding new N assets
to K benchmark assets

Empirical results on international diversification
benefits
Tianqi Wang
Data
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

52 countries sample…..23 developed countries, 29
developing countries
Time…..1985-2002, monthly
Developed countries…..MSCI
Developing countries…..S&P/IFC Global Index
Risk-free rate…..3-month US Treasury bills rate
GDP per capita, stock market capitalization, private
credit to GDP, trade to GDP from World Development
Indicators of the World Bank
Country risk…..Country risk ratings reported by ICRG
Estimation of diversification
benefits
Three conditions:
(i)
No short selling constraints.
(ii)
Short selling constraints in developing countries only.
(iii) Short selling constraint in all countries.
 Two estimations methods:
(i)
Increase in Sharpe ratio(SR)
(ii)
Increase in expected return(ER)
 Return expressed by two currencies:
(i)
Local currency
(ii)
US dollars

Estimation results
Estimation results (cont.)
Estimation results (cont.)
For regional diversification benefits:
 The increase in expected return for Eastern European countries of
investing in the region is 0.3% per month on average as expressed
in US dollar terms, even when short selling constraints are present.
 For other regions no improvements in expected returns can be
obtained from investing within the region when short selling
constraints are present.
For global diversification benefits:
 For most countries, the benefits of global diversification
significantly outweigh the benefits of regional diversification, and
the benefits are also more significant in a statistical sense.
 The increase in expected return as a result of global diversification
under the assumption of no market frictions and expressed in local
currency returns ranges from a low of 0.0% per month for the
Netherlands and Switzerland to a high of 3.3% per month for
Argentina.
Rejection of spanning tests by region
Results on the statistical tests of
mean–variance spanning


For global diversification, the spanning hypothesis is
rejected for all countries at the 1% confidence level,
both when assuming no short-selling constraint and
short selling constraints in developing countries only.
When short-selling constraints are added for all
countries, the global spanning hypothesis is not
rejected for 18 out of the 52 countries in the sample,
suggesting that short-sales constraints on all assets
eliminate the diversification benefits for a substantial
number of countries.

Explaining the cross-country variation in
diversification benefits
Tianqi Wang
What are the factors that explain the
cross-country differences?



Previous research has shown that many developing
countries are not (well) integrated with world capital
markets (Harvey, 1995). This would suggest that there
are substantial benefits to international portfolio
diversification for investors in less developed countries.
To test for this hypothesis the paper use a regression
framework that controls for other country-specific
factors.
The paper only use the increase in the Sharpe ratio as a
measure for diversification benefits for this crosscountry analysis.
Cross-country estimation model
Independent variables:
 Stock market capitalization-----proxy for size of the
stock market
 Trade to GDP -----proxy for trade openness
 Private sector credit to GDP -----proxy for the level of
financial sector development of the country
 ICRG risk ratings-----proxy for the country risk,
including all factors that could contribute to the degree
of stock market integration
Dependent variable:
 Difference between the Sharpe ratio of the global
portfolio (including the local index) and the Sharpe
ratio of the local index
Cross-country differences in the benefits
of foreign diversification
Cross-country estimation results

Of all the country-specific variables that the paper
investigated,only the ICRG country risk rating to
be a statistically significant explanatory variable for
the increase in the Sharpe ratio variable.

Diversification benefits are much larger for
countries with higher country risk.

Time-varying diversification benefits
Lucie Wdowyczynová
Time-varying diversification benefits

The results from the previous section should imply that
if country risk decreases, the diversification benefits
decrease


in this part it is tested
To measure the time-varying diversification benefits,
the model observes:
expected returns
 variances
 and correlations

…for each stock market as a function of the country risk
of the country
Time-varying diversification benefits (cont.)




A proxy for country risk – the ICRG composite risk
index
Analysis os time-varying diversification benefits
performed for both developed and developing countries
The results for developing countries are more
important (the largest variation in country risk)
For developed countries other factors besides country
risk may be more important
Models

Expected returns modeled as a linear function of country risk:
𝐸𝑡 𝑅𝑖,𝑡+1 = 𝛼𝑖 + 𝛽𝑖 𝐼𝐶𝑅𝐺𝑖,𝑡

Variance as an exponential function
𝑉𝑡 𝑅𝑖,𝑡+1 = exp(𝛾𝑖 + 𝛿𝑖 𝐼𝐶𝑅𝐺𝑖,𝑡 )

Correlations take values smaller or equal to one in absolute terms
𝜌𝑡 𝑅𝑖,𝑡+1 , 𝑅𝑗,𝑡+1 = 2Φ(ζ𝑖𝑗 + η𝑖𝑗 𝐼𝐶𝑅𝐺𝑖,𝑡 ) – 1
i…indicates country, j…indicates regional or global index
Models (cont.)

For each country, estimations have been done using
(nonlinear) regression:
Estimation results
Comments on results


For the median country an increase in the ICRG
measure ⇨ an increase in the correlation with
global indices, a decrease in variance and expected
return of the local index – holds for 42/52 countries
Explanatory power and the statistical significance
not very large, but ICRG seems to pick up
economically important swings in exp. returns,
variances and correlations
Comments on results (cont.)

For most countries the country risk as well as the
diversification benefits have decreased over the
period 1985-2002
 The
decrease is significant for regions with many
developing countries
 Much of the difference with developed countries has
disappeared over the 1985-2002 period

Conclusions
Lucie Wdowyczynová
Conclusions




There exist substantial regional and global
diversification benefits for domestic investors in
both developed and developing countris
Benefits of international portfolio diversification
are larger for developing countries
Country risk – good determinant of diversification
benefits
Diversification benefits have decreased over period
1985-2002 (improvements in country risk over
time)
Conclusions (cont.)





The article offers a local rather than a US perspective
For investors in many non-American countries the
potential benefits from investing abroad are still
substantial
Mean-variance investors are substantially worse off in
less developer countries when not investing abroead
Restrictions exist – a further liberalization of
international financial markets needed
Globally oriented mutual funds in developing countries
may foster diversification benefits
References

Driessen, J., Laeven, L., 2007. “International
Portfolio Diversification Benefits: Cross-Country
Evidence from a Local Perspective”. Journal of
Banking and Finance, 31, pp. 1693-1712.