Global Asset Allocation: New Methods and Applications (Wiley Finance)

337 Pages·2002·3.87 MB·English

by  Heinz Zimmermann

Global Asset
Allocation
John Wiley & Sons
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Global Asset
Allocation
New Methods and Applications
HEINZ ZIMMERMANN
WOLFGANG DROBETZ
PETER OERTMANN
John Wiley & Sons, Inc.
Copyright © 2003 by Heinz Zimmermann, Wolfgang Drobetz, and Peter Oertmann. All
rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
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Library of Congress Cataloging-in-Publication Data:
Zimmermann, Heinz.
Global asset allocation : new methods and applications / Heinz
Zimmermann, Wolfgang Drobetz, Peter Oertmann.
p. cm. — (Wiley finance series)
ISBN 0-471-26426-1 (cloth : alk. paper)
1. Asset allocation. 2. Investments, Foreign. 3. Globalization
—Economic aspects. I. Drobetz, Wolfgang. II. Oertmann,
Peter. III. Title. IV. Series.
HG4529.5.Z56 2003
332.67’3—dc21 2002009972
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
preface
This book is about global asset allocation decisions. The benefits of
international asset allocation have been recognized for a long time.
H. Grubel, H. Levy, M. Sarnat, and B. Solnik demonstrated the bene-
fits of international diversification more than 25 years ago, when only
a small number of global investment opportunities were available. This
picture has drastically changed. Most institutional investors, such as
pension plans or insurance companies, invest a substantial part of
their assets in foreign markets, sectors, and currencies, and mutual
funds offer a wide range of global investment products at reasonable
cost. The globalization of the economy has progressed dramatically in
this time period, which is particularly true for the internationalization
of the financial system, including the banking sector. Financial ser-
vices have become a truly global business.
Many excellent books have been published on these topics over
the past years, for example, Frankel (1994), Ledermann and Klein
(1994), Giddy (1994), Jorion and Khoury (1995), Solnik (2000),
Smith and Walter (2000), to mention just a few. The distinguishing
feature of this book is its attempt to incorporate recent methodologi-
cal advances in the treatment of the various topics. Much progress has
been made in the statistical modeling of time-varying risk and return
characteristics of financial markets. These tools make it possible to
shed new light on the time-varying relationship between volatility and
the correlation between markets and sectors, and to investigate the
implications for international asset allocation strategies. This litera-
ture also suggests a “dynamic” view of the risk-return trade-off of fi-
nancial assets: Risk premia are time-varying and predictable based on
changing business conditions. Numerous econometric research has
tested the time-series and cross-sectional implications of conditional
multifactor asset pricing models. This research has major implica-
tions for the implementation of dynamic (tactical) asset allocation
v
vi PREFACE
strategies, as well as the measurement of investment performance. Fi-
nally, a substantial part of the recent progress in the asset pricing lit-
erature relies on test strategies based on stochastic deflators. This
approach is extremely useful to investigate the degree to which mar-
kets are integrated or segmented in terms of the pricing of systematic
risk across national borders, sectors, or entire asset classes. This has
important implications for asset allocation strategies, but also for
corporate funding decisions.
This book focuses on the practical applications of these method-
ological advances for global asset pricing and portfolio decisions.
Original empirical work is presented throughout the book.
Most of the chapters were originally presented at two Global
Asset Allocation Conferences organized by Peter Oertmann and
Heinz Zimmermann in October 1999 and October 2000, respec-
tively, in Zurich, Switzerland. We are grateful to the Swiss Institute of
Banking and Finance (s/bf) at the University of St. Gallen for hosting
the conferences. The senior author of this book was then a director
of the Institute. The presented papers were evaluated by the organiz-
ers of the first conference, and a few were refereed by outside re-
viewers. Earlier versions of Chapters 4 and 10 were published in the
Journal of Financial Markets and Portfolio Management, where a
German version of Chapter 6 was published also. All chapters have
been updated and revised from the papers originally presented.
While the three authors of this book bear full responsibility for
the content of this volume, we gratefully acknowledge the contribu-
tion of David Rey, the author of Chapter 4, who did an excellent job
in preparing the final version of the entire manuscript; and of Viola
Markert, co-author of Chapter 8. We also acknowledge the motivat-
ing comments and suggestions by the participants of the conferences,
as well as by our students and colleagues. We hope that this volume
will stimulate further research in this area.
HEINZ ZIMMERMANN
WOLFGANG DROBETZ
PETER OERTMANN
Basel and St. Gallen, Switzerland
October 2002
contents
CHAPTER 1
The Global Economy and Investment Management 1
Executive Summary 1
Motivation 2
Globalization and Risk 2
Globalization and Expected Returns 3
Globalization and the Market Price of Risk 4
Tactical Asset Allocation and Estimation Risk 4
About This Book 5
CHAPTER 2
International Asset Pricing, Portfolio Selection, and
Currency Hedging: An Overview 7
Executive Summary 7
Introduction 8
Valuation in an International Setting: Basic Facts 9
Purchasing Power Relationships 10
The Core Problem of International Asset Pricing 12
Portfolio Selection and Asset Pricing I 13
Utility-Based Asset Pricing Models—Overview 13
The Basic International Capital Asset Pricing
Model (IntCAPM) without Deviations from PPP 14
Portfolio Separation and the IntCAPM in Real Terms 15
The IntCAPM in Nominal Terms 16
Portfolio Selection and Asset Pricing II 18
Accounting for PPP Deviations and “Real”
Exchange Rate Risk 18
The Solnik-Sercu International Asset Pricing Model 19
From Partial to General Equilibrium 27
General Models Accounting for Domestic Inflation 30
Currency Hedging 36
Equilibrium Currency Hedging 37
Universal Currency Hedging 38
vii
viii CONTENTS
Free Lunch and Full Currency Hedging 39
Overlay Currency Hedges 40
International Arbitrage Pricing Theory 41
Pricing Condition with Currency Risk Adjustment 42
The Solnik Pricing Condition 45
Summing Up the Main Streams 47
CHAPTER 3
The Anatomy of Volatility and Stock Market Correlations 51
Executive Summary 51
Introduction 51
Data and Descriptive Statistics 53
An Asymmetrical Model of Volatility 58
The Correlation Structure of International Stock Returns 64
Correlation and Volatility 64
Upmarket and Downmarket Correlations 70
Business Cycles and Correlations 74
Investment Implications 76
Diversification in Upmarkets and Downmarkets 77
Shortfall Risk 79
Value-at-Risk 80
Option Pricing 84
Conclusion 86
CHAPTER 4
The Correlation Breakdown in International Stock Markets 89
Executive Summary 89
Motivation 90
Analysis of the Stock Return Series 91
Description of the Data 92
Summary Statistics 92
International Equity Market Correlations 93
Time-Measured Observations 95
Moving Estimation Windows 96
Realized Correlation Constructed from Daily Data 98
Is There a Time Trend? 101
Event-Measured Observations 105
Correlation Breakdown 105
What Actually Is an (Extreme) Event on Financial Markets? 106
Contents ix
Empirical Evidence: Based on Realized Correlations 107
Empirical Evidence: Based on Monthly Return Data 110
Implications for Asset Management 115
Optimal Portfolios from Event-Varying
Variance-Covariance Matrices 116
Conclusion 119
CHAPTER 5
Global Economic Risk Profiles: Analyzing Value and Volatility
Drivers in Global Markets 121
Executive Summary 121
Introduction 121
Empirical Methodology 123
The Return-Generating Process 124
The Pricing Restriction 125
Data Description 126
Stock and Bond Market Returns 126
Specification of Global Risk Factors 127
GERP—A First Inspection of the Markets’ Risk Profiles 129
Factor Profiles for Stock Markets 131
Factor Profiles for Bond Markets 133
Explanatory Power of the Factor Models 133
Discriminating between Volatility and Value Drivers 134
Testing the Pricing Potential of the Risk Factors:
Wald Tests 134
Potential Value Drivers for Stock Markets 135
Potential Value Drivers for Bond Markets 137
Choosing the Common Factors 137
Assessing the Power of Value Drivers: Testing the
Pricing Equation 138
Conclusion 141
Appendix 142
CHAPTER 6
Testing Market Integration: The Case of Switzerland and Germany 145
Executive Summary 145
Introduction 146
Integration and Correlation 150