Asset co-movement and diversification benefits

Diversification is said to be the only free lunch in finance. However, the amount of risk that can be reduced by forming a diversified portfolio depends on the correlation structure of the assets in the portfolio. This dissertation investigates the co-movement properties of the most common asset classes, develop tools to examine asset co-movements, and improve the measures for evaluating diversification benefits.; Chapter 1, Macroeconomic Factors and the Correlation of Stock and Bond Returns, examines the correlation between stock and bond returns. An asset pricing model is employed to show that the correlation of stock and bond returns can be explained by their common exposure to macroeconomic factors. Empirical results indicate that the major trends in stock-bond correlation are determined primarily by uncertainty about expected inflation. Unexpected inflation and the real interest rate are significant to a lesser degree. Forecasting this stock-bond correlation using macroeconomic factors also helps improve investors' asset allocation decisions.; Chapter 2, Long-Term Global Market Correlations (With William N. Goetzmann and K. Geert Rouwenhorst), is a study of global equity markets in the long-term historical context. In this paper we examine the correlation structure of the major world equity markets over the past 150 years. We find that correlations vary considerably through time and are highest during periods of economic and financial integration. Our analysis suggests that the diversification benefits to global investing are not constant, and that they are currently low compared to the rest of capital market history. We decompose the diversification benefits into two parts: a component that is due to variation in the average correlation across markets, and a component that is due to the variation in the investment opportunity set.; Chapter 3, An Economic Measure of Diversification Benefits, develops a utility based economic measure for diversification benefits, calculated as the maximum premium that an investor is willing to pay for holding a more diversified portfolio. The utility based economic measure allows one to evaluate the expansion of the investment opportunity set by combining the information in both risk and return properties. It also offers a flexible framework to examine how investors with different tolerances for risk may respond to the expansion of the investment opportunity set. This measure is contrasted with the results of mean-variance spanning tests. Empirical analysis shows that investors enjoy substantial diversification benefits by adding emerging stock markets and major bond markets to the existing portfolio of G7 stock markets. Investors' risk tolerance affects their evaluation of new assets. Short-sale constraints reduce, but do not eliminate, diversification benefits.