International Diversification: An Extreme Value Approach

International diversification has costs and benefits, depending on the degree of asset dependence. In light of theoretical research linking diversification and dependence, we examine international diversification with two dependence measures: correlations and extreme dependence. We document several findings. First, dependence has generally increased over time. Second, there is evidence of asymmetric dependence or downside risk in all regions, albeit at different times. Surprisingly, recent Latin American returns exhibit little downside risk. Third, Latin America exhibits a great deal of correlation complexity. Fourth, extreme dependence is related to returns. Our results suggest international limits to diversification. They are also consistent with a possible tradeoff between international diversification and systemic risk.

Introduction: Understanding the net benefits of international diversification is important in today’s eco-nomic climate. In general, the balance between diversification’s benefits and costs hinges on the degree of dependence across securities, as observed by Samuelson (1967), Veldkamp and Van Nieuwerburgh (2008), Ibragimov, Jaffee, and Walden (2009b), and Shin (2009), among others. Diversification benefits are typically assessed using a measure of depen-dence, such as correlation. It is therefore vital for investors to have accurate measures of dependence. There are several measures available in finance, including the traditional correlation and extreme dependence. While each approach has advantages and disadvan- tages, they rarely have been compared in the same empirical study. 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.

Author: Loran Chollete,Victor de la, Pena, Ching-Chih Lu

Source: University of Stavanger

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International Diversification: An Extreme Value Approach