Volatility states and international diversification of international stock markets

Abstract

This study uses a Markov-switching technique to identify the volatility state of international stock markets. Further, we consider four possible state combinations of the individual and world stock markets to examine an interesting issue regarding the relationship between international diversification and market volatility. Last, we adopt a framework based on the state-varying correlation to establish a more efficient international investment strategy. Our empirical results are consistent with the two following notions. First, the situation of both the individual and world stock markets during high volatility states will be associated with the minimum benefit of risk-reduction from international diversification and a maximum cross-market correlation. Second, by incorporating the character of state-varying correlation into the establishment of an international portfolio, we can create a more efficient investment strategy with less risk, or greater return for a given risk.