International Diversification When Equity Returns and Exchange Rates Are Correlated

In this paper we investigate the diversification effects when stock market returns are c orrelated with foreign exchange rates. We first show that when equity markets and cu rrency market are correlated, even an identical equally weighted portfolio using equiti es from two countries will yield different diversification effects depending on which c ountry’s currency the returns are measured. We develop a measure of comparative ad vantage in risk reduction for a pair of countries, and conduct empirical analyses on st ock indices of 31 countries. The main result suggests that movements in the exchang e rates tend to add risks to the investors from most of the developed countries when th ey invest in emerging markets, while provide hedges to the investors from most of the emerging markets when they invest in developed markets.