International portfolio choice and the sources of non-diversification

Economic theory implies that international portfolio diversification yields a greater rate of return for a given level of risk than portfolio diversification within a single country. Prior to the 1980s, regulatory restrictions significantly hindered international asset flows and resulted in low levels of observed international diversification. As the regulatory impediments declined throughout the 1980s, economic theory suggests a corresponding increase in international diversification. Up to the present however, the increase in international diversification has been significantly smaller than anticipated.;One explanation for the observed low level of international diversification is that transaction costs impede portfolio reallocation. In chapter one, a multi-asset model is used to investigate the implications of transaction costs on international portfolio allocations. Numerical simulation techniques are employed to study the evolution of an international portfolio and the behavior of net equity purchases. The model implies that investment activity decreases as the magnitude of the transaction costs increases. Proportional transaction costs of reasonable size do not, however, induce the investor to retain a high percentage of the portfolio in the domestic security because over the long-term benefits of diversification outweigh the short-term costs.;Another possible explanation for the low level of observed international diversification is that the benefits explained by country-specific indices do not capture the actual diversification opportunities inherent in a comprehensive set of domestic assets. In chapter two, mean-variance spanning tests are used to examine the sources of gains from international diversification from a diverse set of domestic assets. The null hypothesis that a portfolio of domestic stocks spans the risk and return opportunities of a portfolio that includes domestic and multinational stocks is not rejected for most countries over most time periods. The null hypothesis that a portfolio of domestic stocks--inclusive of multinationals--spans a larger portfolio that includes both domestic stocks and the international market indices is rejected. The economic importance of the shift of the portfolio frontier--measured as the utility gain from diversification--varies considerably from market to market and often reflects the benefits of large short positions in certain markets.