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The Influence of Domestic and Foreign Shocks on Portfolio Diversification Gains and the Associated Risks

School of Economics, Finance and Marketing, RMIT University, Melbourne VIC 3000, Australia
J. Risk Financial Manag. 2019, 12(4), 160; https://doi.org/10.3390/jrfm12040160
Received: 8 July 2019 / Revised: 29 September 2019 / Accepted: 8 October 2019 / Published: 10 October 2019
(This article belongs to the Special Issue Quantitative Risk)
This paper evaluates the influence of foreign or domestic stock market return and return of volatility shocks on dynamic conditional correlations (DCCs) between international stock markets and correlation volatility, respectively. The correlations between markets have implications for the gains from portfolio diversification, while correlation volatilities can be seen as risks to portfolio diversification. Meanwhile, domestic shocks are sourced from the return and return volatility from 24 developed, emerging, and frontier stock markets. The US stock market is the source of foreign shocks. The domestic and foreign shocks are derived using market-based returns and under bearish market conditions. We estimate multivariate exponential generalized autoregressive conditional heteroskedasticity (E-GARCH) models using daily and monthly MSCI based stock price data of selected developed, emerging, and frontier markets over 1993:1–2014:1. Our key results are as follows. Domestic market shocks were significant drivers of gains from portfolio diversification most of the time, although the US market effects were relatively stronger. On the other hand, the US, in terms of the number of significant cases as well as the size effects of shocks, dominated as a determinant of correlation volatility (or risks to portfolio diversification). Further, under bear market conditions, adjustments in correlations and correlation volatilities are found to be mostly US-induced. Bearish shocks, rather than market return based shocks, show strong evidence of the leverage effect. Signs of persistence of shocks are mainly noticed under bearish conditions. View Full-Text
Keywords: return shocks; volatility shocks; frontier markets; emerging markets; developed markets; correlations; asymmetric correlations return shocks; volatility shocks; frontier markets; emerging markets; developed markets; correlations; asymmetric correlations
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Narayan, S. The Influence of Domestic and Foreign Shocks on Portfolio Diversification Gains and the Associated Risks. J. Risk Financial Manag. 2019, 12, 160.

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