Dependence Structure and Extreme Comovements in International Equity and Bond Markets with Portfolio Diversification Effects

Abstract

Equity returns are more dependent in bear markets than in bull markets. Previous studies have argued that a multivariate GARCH model or a regime switching (RS) model based on normal innovations could reproduce this asymmetric extreme dependence. We show analytically that it cannot be the case. We propose an alternative model that allows for tail dependence in lower returns and keeps tail independence for upper returns. This model is applied to international equity and bond markets to investigate their dependence structure. It includes one normal regime in which dependence is symmetric and a second regime characterized by a symmetric dependence. Empirical results show that the dependence between equities and bonds is low even in the same country, while the dependence between international assets of the same type is large in both regimes. The cross-country dependence is especially large in the asymmetric regime. Exchange rate volatility seems to be a factor contributing to asymmetric dependence. With the introduction of a fixed exchange rate the dependence between France and Germany becomes less asymmetric and more normal than before. High exchange rate volatility is associated with a high level of asymmetry. Empirical phenomena such as home bias investment and flight to safety are amplified by asymmetric dependence through coskewness. For a US investor who holds US and Canadian bonds and equities, the share invested in Canada increases with the asymmetric dependence since the Canadian market in our sample is less risky. However, when the adjustment for perceived risk is made to take into account the asymmetric information the result changes and asymmetric dependence increases the home investment. A similar behavior is observed for the bond and equity trade-off. In the asymmetric dependence regime, the very risk-averse agent increases the fraction of its wealth in bonds.