International Asset Pricing and Portfolio Diversification with Time-Varying Risk




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    • Marshall School of Business, University of Southern California. An earlier version of this article was circulated under the title “Time-varying risk and international portfolio diversification with contagious bear markets.” We thank the editor, René Stulz, an anonymous referee, Geert Bekaert, Fischer Black, Tim Bollerslev, Peter Bossaerts, Andrea Buraschi, John Cochrane, Campbell Harvey, Selo Imrohoroglu, Philippe Jorion, John Matsusaka, Hans Mikkelsen, Franz Palm, Aris Protopadakis, Allan Timmermann, and Arnold Zellner, as well as seminar participants at the University of Southern California, the Federal Reserve Bank of Minneapolis, UC Santa Barbara, UCLA, UC San Diego, HEC Lausanne, Free University of Brussels, University of Michigan, University of Washington, CEPR-LIFE Workshop on International Finance in Maastricht, WFA meetings in Aspen, CEPR Summer Symposium in Gerzensee and EFA meetings in Milan for many valuable comments. Gérard acknowledges research support from the ZFRIF fund at USC.


We test the conditional capital asset pricing model (CAPM) for the world's eight largest equity markets using a parsimonious generalized autoregressive conditional heteroskedasticity (GARCH) parameterization. Our methodology can be applied simultaneously to many assets and, at the same time, accommodate general dynamics of the conditional moments. The evidence supports most of the pricing restrictions of the model, but some of the variation in risk-adjusted excess returns remains predictable during periods of high interest rates. Our estimates indicate that, although severe market declines are contagious, the expected gains from international diversification for a U.S. investor average 2.11 percent per year and have not significantly declined over the last two decades.