Assessing the benefits of international portfolio diversification in bonds ...

Format: (210.00 x 297.00 mm); Date: Mar 13, 2008 16:49:21; Output Profile: SPOT ISO Coated v2 (ECI); Preflight: Failed

WO R K I N G PA P E R S E R I E S NO 883 / MARCH 2008

ASSESSING THE BENEFITS OF INTERNATIONAL PORTFOLIO DIVERSIFICATION IN BONDS AND STOCKS

by Roberto A. De Santis and Lucio Sarno

WO R K I N G PA P E R S E R I E S N O 8 8 3 / M A R C H 20 0 8

ASSESSING THE BENEFITS OF INTERNATIONAL PORTFOLIO DIVERSIFICATION IN BONDS AND STOCKS 1 by Roberto A. De Santis 2 and Lucio Sarno 3

In 2008 all ECB publications feature a motif taken from the 10 banknote.

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: [email protected] 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: [email protected]

© 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 reflect 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/scientific/wps/date/html/ index.en.html ISSN 1561-0810 (print) ISSN 1725-2806 (online)

CONTENTS Abstract

4

Non-technical summary

5

1 Introduction

7

2 A factor pricing model of exchange rates, bonds and stocks 2.1 Setup 2.2 Uncovered interest rate parity 2.3 Uncovered return parity for equities and bonds 2.4 Equity and bond returns equilibrium 2.5 The full parity system

10 10 11 11 12 12

3 Empirical implementation 3.1 GMM estimation and restrictions to test comovement 3.2 Stochastic discount factor 3.3 Risk premia

13

4 Data

15

5 Empirical results 5.1 The base case 5.2 The US discount factor 5.3 The model with time-varying risk premia 5.4 Performance of global and domestic portfolios 5.5 Time-varying comovement from the 1980s

17 17 18 19

6 Concluding remarks

23

References

25

Tables and figures

29

European Central Bank Working Paper Series

41

13 14 15

20 22

ECB Working Paper Series No 883 March 2008

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