Journal
REVIEW OF FINANCIAL STUDIES
Volume 15, Issue 4, Pages 1137-1187Publisher
OXFORD UNIV PRESS INC
DOI: 10.1093/rfs/15.4.1137
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Correlations between international equity market returns tend to increase in highly volatile bear markets, which has led some to doubt the benefits of international diversification. This article solves the dynamic portfolio choice problem of a U.S. investor faced with a time-varying investment opportunity set modeled using a regime-switching process which may be characterized by correlations and volatilities that increase in bad times. International diversification is still valuable with regime changes and currency hedging imparts further benefit. The costs of ignoring the regimes are small for all-equity portfolios but increase when a conditionally risk-free asset can be held.
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