An important issue in international economics concerns the size of benefits from diversifying over securities in foreign countries, especially securities in emerging markets. In theory, if foreign securities do not perfectly correlate with U.S. securities, domestic investors gain from international diversification. However, the magnitude of the diversification benefits in general depends on various portfolio constraints, such as investors ability to take short positions.
Given the existence of derivative securities on stock market indices in developed countries, it is often feasible for institutional investors to take short positions on developed markets. Investors nonetheless face short-sale constraints in many emerging markets. In this paper, we study the impact of short-sale constraints on the existence and magnitude of international diversification benefits to U.S. equity investors. The existence of substantial diversification benefits of investing in emerging markets subject to short-sale constraints will underscore the importance of international diversification.
Short-sale constraints have gained increasing attention in recent finance literature. Sharpe (1991) conjectures that departures from the CAPM might be small even in the extreme case where negative holdings are excluded. He postulates that institutional arrangements to improve investors abilities to take negative positions facilitate the efficient allocation of risk in the economy. Hansen, Heatonand Luttmer (1995), He and Modest (1995), and Luttmer (1996) study how short-sale constraints and transactions costs affect consumption-based asset pricing models. For portfolio efficiency subject to short-sale constraints, Wang (1998) conductsBayesian inference, Basak, Jagannathanand Sun (2000) develop an asymptotic test, and De Roon, Nijmanand We rker (2001) carry out regression-based tests for mean variance spanning.
Ignoring short-sale constraints, many studies have documented low correlation across international markets and substantial diversification benefits. The early literature of Grubel (1968), Levy and Sarnat (1970), and Lessard (1973) finds low correlation among equity re-turns in industrial countries and concludes that the gain from international diversification is substantial. Harvey (1995) shows that securities in emerging markets promise U.S. investors both high expected returns and risk, as well as low correlation with securities in developed markets.
Bekaert and Urias (1996) reject the hypothesis that equity indices in industrial countries span the mean-variance frontier of all international equity indices and thus demonstrate the existence of diversification benefits in emerging markets. Using the international CAPM, De Santisand Gerard (1997) estimate that the expected gain from international diversification toa U.S. investor is on average 2.11 percent annually. Errunza, Hogan and Hung (1999) further show that the international diversification benefits can be obtained from investment in country funds and American Depository Receipts traded in U.S.
Download
Diversification benefits of emerging markets subject to portfolio constraints
