WORKING PAPER SERIES NO 883 / MARCH 2008 ASSESSING THE BENEFITS OF INTERNATIONAL PORTFOLIO DIVERSIFIC ATION IN BONDS AND STOCKS by Rober to A. De Santis and Lucio Sarno Format: (210.00 x 297.00 mm); Date: Mar 13, 2008 16:49:21; Output Profile: SPOT ISO Coated v2 (ECI); Preflight: Failed WORKING PAPER SERIES NO 883 / MARCH 2008 In 2008 all ECB publications feature a motif taken from the 10 banknote. ASSESSING THE BENEFITS OF INTERNATIONAL PORTFOLIO DIVERSIFICATION IN BONDS AND STOCKS 1 by Roberto A. De Santis 2 and Lucio Sarno 3 This paper can be downloaded without charge from http://www.ecb.europa.eu or from the Social Science Research Network electronic library at http://ssrn.com/abstract_id=1105383. 1 This paper was partly written while Lucio Sarno was a Visiting Scholar at the International Monetary Fund. We are grateful for constructive comments at various stages of this paper to Lorenzo Cappiello, John Cochrane and Robert Engle. The authors alone are responsible for the views expressed in the paper and for any errors that may remain. 2 Corresponding author: European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany; Tel: +49 69 1344 0; e-mail: roberto.de_santis@ecb.int 3 University of Warwick and Centre for Economic Policy Research (CEPR). Contact address: Finance Group, Warwick Business School, University of Warwick, Coventry CV4 7AL, United Kingdom; e-mail: lucio.sarno@wbs.ac.uk © European Central Bank, 2008 Address Kaiserstrasse 29 60311 Frankfurt am Main, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main, Germany Telephone +49 69 1344 0 Website http://www.ecb.europa.eu Fax +49 69 1344 6000 All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the author(s). The views expressed in this paper do not necessarily refl ect those of the European Central Bank. The statement of purpose for the ECB Working Paper Series is available from the ECB website, http://www.ecb. europa.eu/pub/scientifi c/wps/date/html/ index.en.html ISSN 1561-0810 (print) ISSN 1725-2806 (online) 3 ECB Working Paper Series No 883 March 2008 Abstract 4 Non-technical summary 5 1 Introduction 7 2 A factor pricing model of exchange rates, bonds and stocks 10 2.1 Setup 10 2.2 Uncovered interest rate parity 11 2.3 Uncovered return parity for equities and bonds 11 2.4 Equity and bond returns equilibrium 12 2.5 The full parity system 12 3 Empirical implementation 13 3.1 GMM estimation and restrictions to test comovement 13 3.2 Stochastic discount factor 14 3.3 Risk premia 15 4 Data 15 5 Empirical results 17 5.1 The base case 17 5.2 The US discount factor 18 5.3 The model with time-varying risk premia 19 5.4 Performance of global and domestic portfolios 20 5.5 Time-varying comovement from the 1980s 22 6 Concluding remarks 23 References 25 Tables and fi gures 29 European Central Bank Working Paper Series 41 CONTENTS 4 ECB Working Paper Series No 883 March 2008 $453#%5 +:;E B3B7D 5A@E;67DE 3 EFK>;L76 3EE7F BD;5;@9 ?A67> I:7D7 F:7 D7FGD@E 8DA? 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F:7 73D>K E 3@6 GE7 DA>>;@9 %% 7EF;?3F;A@ FA ?73EGD7 F:7 679D77 A8 5A?AH7?7@F AH7D F;?7 GE;@9 3 F;?7H3DK;@9 F7EF 8AD 5A?AH7?7@F 'H7D3>> I7 M@6 F:3F F:7 EFD7@9F:7@;@9 A8 5A?AH7?7@F ;E @7;F:7D 3 9D36G3> BDA57EE @AD 3 9>A43> B:7@A?7@A@ D7;@8AD5;@9 F:7 53E7 8AD ;@F7D@3F;A@3> ;F ;E :3D6 FA F7EF F:7 D;E=3D4;FD397 D7EFD;5F;A@E FA 3EE7EE F:7 BAF7@F;3> 679D77 A8 6;H7DE;M53F;A@ 93;@E  7=37DF 3@6 3DH7K  BDABAE7 3 ?7F:A6A>A9K F:3F 3>>AIE 8AD F:7 679D77 A8 ?3D=7F ;@F79D3F;A@ FA 5:3@97 F:DAG9: F;?7 E77 3>EA 7=37DF 3DH7K 3@6 &9  3DD;7D; DDG@L3 3@6 A93@  >AA6 3@6 )AE7  34 3>EA 67H7>AB F7EFE 8AD 3EE7F ?3D=7F ;@F79D3F;A@ 43E76 A@ 3@ ;@F7DF7?BAD3> 3EE7F BD;5;@9 ?A67> [...]... Testing the hypothesis of ‘no diversification gains’ This table presents confidence intervals for the Wald test on the coefficients reported in Table 4 L stands for lower estimate of the 95% confidence interval U stands for upper estimate of the 95% confidence interval The restrictions to test the null hypothesis of no diversification gains in system (14) are: ˆ 0 ˆ 0 ˆ 0 0 , ˆ 1 1 0 , ˆ1 ˆ1 0 The. .. The results refer to the estimation of system (14) by one stage GMM estimation with the optimal weighting matrix being the unity matrix The instruments used in the system are: lagged one-period earnings yields and lagged one-period change in earnings yields in both the domestic country and the US for stocks; lagged one-period excess bond returns and lagged one-period change in excess bond returns in. .. Table 5 The US SDF and estimated expected excess returns The results refer to the estimation of system (16) by one stage GMM estimation with the optimal weighting matrix being the unity matrix The instruments used to construct the managed portfolios are: lagged one-period change in earnings yields in both the domestic country and the US for stocks; lagged one-period change in bond yields in both the domestic... J-stat The results refer to the estimation of system (14) by one stage GMM estimation with the optimal weighting matrix being the unity matrix The estimated coefficients of the system of equations are reported in the first column for each variable Standard errors are reported in parenthesis Estimated constant terms are not reported For methodology and sample period, see text in Table 4 In addition to the. .. from Datastream, the bond price indices are total market returns on 7-10 year maturity benchmarks, the interest rates are for one-month Eurocurrency deposits from the Bank for International Settlements ‘FX’ denotes excess returns for borrowing in US dollars, converting to the domestic currency, lending at the domestic interest rate, and converting the proceed back to dollars The stock and bond returns... currency denominated log asset returns for 19 countries and annualized log foreign exchange (FX) excess returns for 18 currencies The exchange rate returns are excess returns for borrowing in dollars, converting to the foreign currency, lending at the foreign interest rate, and converting the proceeds back to dollars The stock and bond indices are total market returns from Datastream, the interest rates... risk premia are obtained from estimating a BEKK GARCH(1,1) model for each country relative to the US Note that (1) is approximately equal to the sum of (2) and (3), because (2) and (3) are the covariance terms, while (1) is the log of one minus the covariance terms Returns’ variances differentials needed to estimate the full system (14) are reported (in mean) in the last two columns The data are monthly... bond returns and lagged one-period change in excess bond returns in both the domestic country and the US for bonds Standard errors are reported in parenthesis J-Stat denotes the p-value of the Jstatistic to test the null hypothesis that the overidentifying restrictions are satisfied Excess returns are expressed vis-à-vis the US The data are monthly observations from January 1991 through May 2007 Table... returns over the same country’s one-month interest rate The data are monthly observations from January 1991 through May 2007 FX and equity returns differentials Australia Austria Belgium Switzerland Canada Denmark Finland France Germany Ireland Italy Japan Netherlands New Zealand Norway Spain Sweden UK 30 ECB Working Paper Series No 883 March 2008 FX and bond returns differentials Equity and bond returns... stocks; lagged one-period change in bond yields in both the domestic country and the US for bonds Standard errors are reported in parenthesis J-Stat denotes the p-value of the Jstatistic to test the null hypothesis that the overidentifying restrictions are satisfied Estimated market premia and US risk free rate are annualized values The data are monthly observations from January 1991 through May 2007 US . taken from the 10 banknote. ASSESSING THE BENEFITS OF INTERNATIONAL PORTFOLIO DIVERSIFICATION IN BONDS AND STOCKS 1 by Roberto A. De Santis 2 and Lucio. WORKING PAPER SERIES NO 883 / MARCH 2008 ASSESSING THE BENEFITS OF INTERNATIONAL PORTFOLIO DIVERSIFIC ATION IN BONDS AND STOCKS by Rober to A. De Santis and