Abstract
The rapid increase in economic globalization and international diversification of investment portfolios impose new problems in performance assessment and risk management. Research showing relatively low correlation among equities traded in different countries suggests substantial risk reduction is possible from international diversification. In this article, Scherer points to the statistical difficulty of measuring correlation properly for securities traded in national markets that are open and closed at different times in the “same” day. If the trading day starts in Japan, by the time the U.S. stock market opens, the European markets have been trading for hours and the Japanese stock market is already closed. A major event with worldwide implications that occurs during New York trading hours will not show up in the Nikkei until the next day, while it will be reflected in returns on the German DAX either the same day or the next, depending on the time. Procedures that synchronize returns to correct correlation estimates for this effect show that true correlations are much higher than uncorrected estimates computed from “accounting” returns. Without such corrections, risk measures like Value-at-Risk will be significantly underestimated.
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