Journal of International Money and Finance
Volume 62, April 2016, Pages 52–71
 

Paul R. Bergin (a), (b), Ju Hyun Pyun (c), ,
a Department of Economics, University of California at Davis, One Shields Avenue, Davis, CA 95616, USA
b National Bureau of Economic Research, Cambridge, MA, USA
c Business School, Korea University, 145 Anam-Ro, Seongbuk-Gu, Seoul 136-701, Republic of Korea
http://dx.doi.org/10.1016/j.jimonfin.2015.12.012

Abstract
Not only are investors biased toward home assets, but when they do invest abroad, they appear to favor countries with returns more correlated with home assets. Often attributed to a preference for familiarity, this ‘correlation puzzle’ further reduces effective diversification. We use a multi-country general equilibrium model of portfolio choice to study how bilateral equity holdings are affected by return correlations among alternative destination and source countries. From the theoretical model, we develop an empirical approach to estimate a gravity equation for equity holdings that incorporates the overall covariance structure in a theoretically rigorous yet tractable manner. Estimation using this approach resolves the correlation puzzle, and finds that international investors do seek the diversification benefits of low cross-country correlations, as theory would predict.

Keywords
 Stock return correlation; Bilateral equity holdings; International portfolio diversification; Multi-country model; Equity home bias; Correlation puzzle