International Asset Allocation with Regime Shifts

Correlations between international equity market returns tend to increase in highly volatile bear markets, which has led some to doubt the benefits of international diversification. This article solves the dynamic portfolio choice problem of a US investor faced with a time-varying investment opportunity set modeled using a regime-switching process which may be characterized by correlations and volatilities that increase in bad times. International diversification is still valuable with regime changes and currency hedging imparts further benefit. The costs of ignoring the regimes are small for all-equity portfolios but increase when a conditionally risk-free asset can be held. In standard international portfolio choice models such as Sercu (1980) and Solnik (1974a), agents optimally hold the world market portfolio and a series of hedge portfolios to hedge against real exchange rate risk. From the perspective of these models, investors across the world display strongly home-biased asset choices. One popular argument often heard to rationalize the “home bias puzzle” relies on the asymmetric correlation behavior of international equity returns. A number of empirical studies document that correlations between international equity returns are higher during bear markets than during bull markets. If the diversification benefits from international investing are not forthcoming at the time that investors need them the most (when their home market experiences a downturn), the strong case for international investing may have to be re-considered. Our ambition is to formally evaluate this claim. To quantify the effect of these asymmetric correlations on optimal portfolio choice, we need a dynamic asset allocation model that accommodates time-varying correlations and volatilities. In the standard portfolio choice models and their empirical applications (French and Poterba (1991) and Tesar and Werner (1995)) correlations and volatilities are constant. More specifically, our contribution consists of four parts. First, we formulate a data-generating process (DGP) for international equity returns that reproduces the asymmetric correlation phenomenon. The asymmetric exceedance correlations documented by Longin and Solnik (2001) constitute the empirical benchmark we set for our model. We show that a regime-switching (RS) model reproduces the asymmetric exceedance correlations, whereas standard models, such as multivariate normal or asymmetric GARCH models, do not. Second, we numerically solve and develop intuition on the dynamic asset allocation problem in the presence of regime switches for investors with Constant Relative Risk Aversion (CRRA) preferences. Here our contribution extends beyond international finance. There has recently been a resurgence of interest in dynamic portfolio problems where investment opportunity sets change over time. In most of these papers, time-variation in expected returns characterize the changes in the investment opportunity set and the time-variation is captured by a linear function of the state variables. In contrast, expected returns, volatilities and correlations vary with