International Portfolio Diversification: The Role of Risk and Return

This paper explores empirically the role of risk and return factors in the observed evolution of net foreign asset positions of a large number of industrial and developing economies. The paper adopts a dynamic approach in which investors’ portfolios adjust gradually to their long-run equilibrium, which is characterized by a standard Tobin-Markowitz framework. This equilibrium condition is estimated using a new data set on foreign assets and liabilities for a large number of industrial and developing countries spanning the period from 1965 to the present. The dynamic panel estimation procedure allows for unrestricted short-run heterogeneity across countries, using the Pooled Mean Group estimator of Pesaran, Shin, and Smith (1999). The empirical results lend considerable support to the model when applied to countries with low capital controls and/or high and upper-middle income. The results for countries with high capital controls and, especially, lower-income countries are less supportive of the stock equilibrium model.