International Portfolio Diversification: Currency, Industry and Country Effects Revisited

The authors examine the relative importance of country, industry, world market and currency risk factors for international stock returns. Their approach focuses on testing the mean-variance efficiency of the various factor portfolios. An unconditional analysis does not show significant differences between country, industry and world portfolios, nor any role for currency risk factors. However, when the authors allow expected returns, volatilities and correlations to vary over time, they find that equity returns are mainly driven by global industry and currency risk factors. The authors propose a novel test to evaluate the relative benefits of alternative investment strategies and find that including currencies is critical to take full advantage of the diversification benefits afforded by international markets.