International Equity Portfolios Research Articles

Explainable machine learning for financial risk management: two practical use cases

We explore the potential of machine learning (ML) models applied in two financial risk management areas, i.e., credit risk management and financial risk hedging, through two practical use cases. This comparative study starts with the issue of explainability in complex ML models used in peer-to-peer lending for credit risk management. The first use case examines the limitations of using Kernel-SHAP with dependent features and evaluates different methods for estimating these dependencies using the Lending Club dataset. Our results suggest that accounting for feature dependence improves the understanding and robustness of prediction explanations. The second use case investigates a dynamic method for hedging foreign exchange risk in international equity portfolios, emphasizing the importance of accurate forecasts of currency returns. The analysis demonstrates that predictions yielded by ML models can significantly enhance the hedging of portfolios against currency risk. These findings highlight the transformative potential of advanced ML models in financial risk management, showcasing their capability to improve financial risk measurement and management. Further, our study outlines future research directions to advance this field.

Hedging global currency risk: A dynamic machine learning approach

We propose a dynamic method to hedge foreign exchange risk of international equity portfolios. The method is based on the currency return forecasts derived from a set of alternative machine learning models, built on the main factor components of the currency return time series. To illustrate our method, we take the perspective of a US portfolio manager investing in a global equity portfolio of developing and developed economies. The analysis of several model performance indicators, back-tested on data from 27 October 2008 to 30 December 2022, allows to conclude that accurate predictions of global currency factor returns, such as those obtained with non linear machine learning models, can improve currency risk hedging of global equity portfolios.

Crises and Contagion in Equity Portfolios

We examine the international impact of recent financial crises on contagion dynamics within international equity portfolios. First, we highlight the importance of macroeconomics for portfolio weighting for each region, and then we examine contagion via a structural regime-switching model and a contagion test. We also examine sources of contagion using regime variables, crisis events, and macroeconomic variables. In particular, we study the Argentine debt crisis, the US financial crisis, and the EU sovereign debt crisis. The macroeconomic variables include changes in market capitalization, trade integration, GDP growth, inflation rate, and interest rate. We also employ two classifications, one relating to the portfolio weighting scheme and another one that considers implied global and regional betas. The empirical findings reveal the existence of financial contagion for all the crises that we investigate. Both methods produce similar results. Stronger contagion is evident for global rather than regional betas. Europe is the region with the highest level of contagion and the one mostly affected by the crises. As far as macroeconomic variables are concerned, they are very important in two ways. They statistically significantly explain contagion, while they also reveal contagion under various portfolio weighting schemes. Both methods suggest that the Argentinian crisis mainly contributes to contagion. The research implications suggest that asset allocation and portfolio management should consider both the global and the regional aspects of contagion as differences can occur.

Impacts of cross‐border equity portfolio flow and central bank transparency on financial development: The role of economic freedom and international bonds

AbstractWe investigate the effects of international equity portfolio diversification and central bank independence on financial development using panel data from 49 countries from 2001 to 2016. We find that international equity portfolio diversification improves financial development. We correspondingly examine potential factors through which international equity portfolio diversification may impact financial development and find that central bank transparency provides an important channel for improving financial development. We further find that the relationship between international equity portfolio diversification and financial development is sensitive to economic freedom. Concerning sequencing, we find that foreign equity and debt flow are complementary to financial system development. Our results are robust to endogeneity using the exogenous shock of the 2008 financial crisis. This study offers new empirical evidence on the relationship between international capital and financial development.

International Portfolio Choice with Frictions: Evidence from Mutual Funds

Abstract Using data on international equity portfolio allocations by U.S. mutual funds, we estimate a portfolio expression derived from a standard mean-variance portfolio model extended with portfolio frictions. The optimal portfolio depends on the previous month and the buy-and-hold portfolio shares, and a present discounted value of expected excess returns. We estimate expected return differentials and use them in the portfolio regressions. The estimates imply significant portfolio frictions and a modest rate of risk aversion. While mutual fund portfolios significantly respond to expected returns, portfolio frictions lead to a weaker and a more gradual portfolio response to changes in expected returns. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Portfolio diversification during the COVID-19 pandemic: Do vaccinations matter?

The COVID-19 vaccine rollout expects to mitigate the severe negative impacts of the pandemic on global financial markets. Our study provides supporting evidence for this expectation. We find robust evidence that vaccinations significantly reduce the cross-country stock volatility connectedness among G7 nations, suggesting that the diversification benefits of an international equity portfolio may be enhanced during the pandemic when vaccinations accelerate. We present two explanations for this result. First, the vaccine deployment improves stock market return and decreases individual stock market volatility. Second, the vaccine rollout helps a country’s stock market be more resilient to exogenous shocks. We further demonstrate that a global portfolio using a tactical allocation rule based on the intensity of vaccinations can outperform a buy-and-hold portfolio in terms of risk-adjusted returns.

Political uncertainty and cross-border equity portfolio allocation decisions: International evidence

Political risk models highlight that political uncertainty matters for corporate investment decisions. However, how political uncertainty matters for investment allocation decisions is relatively under-explored. In this study, we examine the impact of political uncertainty associated with national elections on foreign equity portfolio in 48 countries. Our results indicate that political uncertainty reduces international equity allocations to the host country and such reduction appears more pronounced in the election year. Further analysis shows that the interaction between political uncertainty and institutional quality has a positive and significant effect on international equity portfolio flow, suggesting that the value of institutional quality outweighs the negative effects of political uncertainty. Lastly, we find equity home bias to be negative and significant; however, the interaction between political uncertainty and equity home bias appears insignificant.

Do commodities hedge regional stock markets at the same effectiveness level? Evidence from MGARCH models

PurposeThis present work aims at looking into whether or not introducing commodities in international equity portfolios helps reduce the market risk and if hedging is carried out with the same effectiveness across different regional stock markets.Design/methodology/approachThe authors determine the optimal hedge ratios and hedging effectiveness of a number of commodity-hedged emerging and developed equity markets, using three versions of MGARCH model: DCC, ADCC and GO-GARCH. The authors also use a rolling window estimation procedure for the purpose of constructing out-of-sample one-step-ahead forecasts of dynamic conditional correlations and optimal hedge ratios.FindingsEmpirical results evince that commodities significantly display effective risk-reducing hedge instruments in short and long runs. The main finding is that commodities do not seem to hedge regional stock markets in the same way. They tend to provide evidence of a rather effective hedging regarding mainly the East European and Latin American stock markets.Originality/valueThe authors study whether commodities can hedge stock markets at regional context and if hedging effectiveness differ from one region to another.

International Equity Portfolio Performance - to Hedge or not to Hedge Foreign Currency Risk

International Equity Portfolio Performance - to Hedge or not to Hedge Foreign Currency Risk

EQUITY MARKETS RISKS AND RETURNS: IMPLICATIONS FOR GLOBAL PORTFOLIO CAPITAL FLOWS DURING PANDEMIC AND CRISIS PERIODS

The paper is devoted to the study of risk and return tradeoff in the global equity market as well as particular market groups: developed, emerging and frontier markets. Impact of this tradeoff on international equity portfolio liabilities is explored. The study confirms the hypothesis that there are some specific patterns of risk and return tradeoff during crisis periods and periods of markets regular regime that substantially differ from each other and define global portfolio equity flows and liabilities in a specific way. The paper thus carries out its main objective that implies revealing these patterns with respective qualitative features and quantitative markers, specifying their implications for equity portfolio flows to markets of different types. Risks and returns for different market groups and global market as a whole are calculated for the period between 2002 and 2020 using standard methodology of contemporary portfolio theory and MSCI indices monthly values. The data for international equity portfolio liabilities as well as the share of particular market group in the global market are used as dependent variables. The latter are regressed by calculated risks and returns. Using the model results and some analytical developments, two patterns of risk/return tradeoff are discovered. The pattern attributable to regular market regimes is characterized by positive returns which is 1.51 % in average for the global market, 1.48 % for developed markets and 2.03 % for emerging markets. Risks in regular pattern are relatively small or moderate at the average level of 3.05 for the global market and are all below the median (3.48). Respective risks for developed and emerging markets are 3.02 and 4.54. The Sharpe ratios in regular pattern are positive at the average level of 0.60 for the global market, 0.57 and 0.45 for developed and emerging market groups respectively. The crisis pattern implies negative returns at the mean of -1.04 for the global market, -0.97 for the developed group and -1.35 for the emerging markets. High risks are all above the median and in average compile 5.5 for the global market, 5.47 for the developed markets and 6.68 for the emerging group. Sharpe ratios for this pattern are negative being equal to -0.19 in the mean. The average value is -0.18 for developed markets and it is -0.24 for emerging markets. Specific pattern of 2020 crisis should be settled out. Its main feature that substantially distinguishes it from other crises is the combination of highest risk level and the positive returns at the same time. Elaborated regression model confirms the direct impact of return and indirect impact of risk on global portfolio liabilities. The influence of risk for regular and crisis patterns does not differ substantially while the impact of return is much stronger during periods of increased volatility (respective model parameters are 3793.76 and 447.24). However, the discovered impact is much more reliable in crisis pattern that is supported by much higher determination ratio. Developed markets experience similar effects.

International Portfolio Investments with Trade Networks

What determines the composition of international portfolio investments remains an open question in international finance. In this paper, I propose a theory of international portfolio choice where trade networks play a key role. I solve in closed form for the optimal equity and bond portfolio investments in a multi-country model with arbitrary global input - output linkages and taste differences. I show that a measure of international demand exposure, called the “International Domar Weights” (IDWs), is key in determining international equity portfolios. The IDWs extend the closed-economy “Domar weights” to the international setting and capture countries' interdependence through both direct and indirect trade linkages. Using data from the World Input - Output Database (WIOD) and Coordinated Portfolio Investment Survey (CPIS), I apply the framework to a network of 43 major developed and emerging economies and obtain four main results. First, the theoretical network portfolio is a significant predictor and explains almost half of the variation in international bilateral portfolio investments. The significance of the network portfolio is robust to controlling for gravity factors (market capitalization, distance, EU membership, etc.). Second, including the network-based portfolio in a gravity model for assets resolves the puzzle of why distance matters for asset trade at all. Third, indirect trade linkages matter for portfolio determination, highlighting the need to explicitly account for trade in intermediate inputs. Finally, the model predicts both the levels and the changes in equity home bias that have occurred since 2000.

Bitcoin, VIX futures and CDS: a triangle for hedging the international equity portfolios

PurposeIn this paper, our aim is to estimate the time varying correlations between Bitcoin, VIX futures and CDS indexes and to examine in what ways these assets can act as beneficial hedge and safe haven mechanisms, useful for facing, or attenuating, the major world equity markets related risks and volatilities.Design/methodology/approachOur methodology consists to model each pair equity/asset indices by bivariate symmetric and asymmetric dynamic conditional models (A) DCC to evaluate the portfolio design associated implications on both daily and weekly collected data base, with regard to the period ranging from July, 2010 to January 2018. To assess the extent to which the Bitcoin, VIX futures and sovereign CDS may stand as diversifiers, i.e. as hedging or safe haven instruments against the various stock indexes, we adopt the same method applied by Baur and Lucey (2010).FindingsEmpirical results show that the hedging and safe haven roles associated with the three hedging instruments tend to differ noticeably across time horizons and model used. The interest brought about by treating this issue is twofold. On the one hand, it should provide useful guidelines to investors through helping them opt for the most effective and beneficial strategies, whereby they could efficiently hedge the equity markets related extreme risks and volatilities. On the other hand, it is intended to highlight the applied models' specifications associated impacts.Research limitations/implicationsThe interest brought about by treating this issue is twofold. On the one hand, it should provide useful guidelines to investors and financial advisors through helping them opt for the most effective and beneficial of the strategies, whereby they could efficiently hedge the equity markets related extreme risks and volatilities. On the other hand, it is intended to highlight the applied models' specifications associated impacts.Originality/valueStudy of Bitcoin can be considered as safe haven or hedge or diversifier instrument. Compare between Bitcoin, VIX and CDs.

Practical Applications of International Equity Indexes and Public Trust

<h3>Practical Applications Summary</h3> In <b><i>International Equity Indexes and Public Trust</i></b>, which appeared in the Summer 2018 issue of <b><i>The Journal of Investing</i>, Lars Kaiser (University of Liechtenstein)</b> investigates the relationship between public trust and international capital flows. He examines whether public trust could serve as an alternative-weighting scheme for international equity portfolios that are traditionally weighted according to gross domestic product (GDP) or market capitalization. He finds that trust-weighted schemes perform similarly to equal-weighted schemes in terms of diversification and returns, but display lower volatility. These findings are particularly robust among emerging markets. Additionally, Kaiser finds an asymmetry between foreign and local public trust in different countries and argues that investors often make decisions based on this informational asymmetry. Overall, he suggests that public trust provides valuable additional information to investors with allocations to international equity, particularly when those allocations are in emerging markets. <b>TOPICS:</b>Portfolio construction, developed

International Portfolio Choice with Frictions: Evidence from Mutual Funds

Using data on international equity portfolio allocations of US mutual funds, we estimate a simple portfolio expression derived from a standard Markowitz mean-variance portfolio model extended with portfolio frictions. The optimal portfolio depends on two benchmark portfolios, the previous month and the buy-and-hold portfolio shares, and a present discounted value of expected future excess returns. We show that equity return differentials are predictable and use the expected return differentials in the mutual fund portfolio regressions. The estimated reduced form parameters are related to the structural model parameters. The estimates imply significant portfolio frictions and a modest rate of risk-aversion. While mutual fund portfolios respond significantly to expected returns, portfolio frictions lead to a weaker and more gradual portfolio response to changes in expected returns. We also document heterogeneity across funds. Global and larger funds face bigger portfolio frictions, while more active funds give relatively less weight to the buy-and- hold portfolio (rebalance more aggressively).

Using CAPE to Forecast Country Returns for Designing an International Country Rotation Portfolio

The cyclically adjusted price-to-earnings ratio (CAPE), though originally derived for the US equity market, has now been calculated for various national equity markets outside the United States. In all its various adaptations, the measure has been used only to express valuations of those markets in terms of being overvalued, undervalued, or fairly valued. None of the adaptations of the measure have been used to derive finite equity return expectations from those markets. This article explores the approach of applying CAPE to develop a computable forecast measure, called the medium-term country yield forecast (CY-M), to express the medium-term real return expectations of national equity markets. In almost all of its past adaptations, CAPE has mostly been used to express only long-term (periods greater than 10 years) valuations of the equity markets, but the author here has explored its application in the medium term (periods between 2 and 10 years). Drawing conclusions from empirical studies on countries in the MSCI All Countries World Index ex. USA (ACWX) for the period 1969 through 2016, the author has amended the CAPE of a national equity market by coalescing it with the cyclically adjusted real exchange rate (computed in the same manner as CAPE) of the country and the long-term price return momentum (adjusted for inflation) of the market. The author also has applied CY-M derived from the adapted CAPE as a comparative measure to screen and rank countries in the ACWX to construct an international country rotation equity portfolio. TOPICS:Portfolio theory, portfolio construction, equity portfolio management, international investing Key Findings • The article illustrates how to adapt CAPE (also known as Shiller’s PE), a popular long-term US equity valuation measure, to be an equally proficient medium-term valuation measure for countries outside the United States. • It elucidates further a mechanism of applying the modified CAPE of a country to frame its medium-term return expectations. • The article also demonstrates how to rank countries based on their medium-term return expectations to construct a country rotation international equity portfolio.

Impact of central bank independence and transparency on international equity portfolio allocation: A cross-country analysis

In this study, we analyse the effects of central bank independence (CBI) and central bank transparency (CBT) and their interactions with institutional quality on foreign equity portfolio inflows. Employing a dataset from 42 countries over the period from 2001 to 2014, we find strong evidence that independent and transparent central bank has a positive and significant influence on foreign equity investment inflows. Further analysis shows that institutional quality interacts with central bank independence and transparency in attracting foreign equity portfolio. Our results are robust to alternative specifications, endogeneity concerns and that economic policy uncertainty increases asymmetric information and deters foreign equity portfolio investment inflows.

Does the Euro–Mediterranean Partnership contribute to regional integration?

The paper investigates whether Southern Mediterranean and Middle Eastern markets under the Euro–Mediterranean Partnership (Egypt, Lebanon, Morocco, Malta, and Turkey) have become more financially integrated with the European stock market over time. The findings suggest that the Turkish equity market is moderately integrated with the European market, while the other economies exhibit weak financial integration with Europe, supporting the idea that the partnership appears to have no effect on enhancing inter-market linkages for these economies. Therefore, these markets would be good destinations for international investors seeking attractive investment opportunities to diversify their equity portfolios. Structural changes in the cross-market integration do exist, which may be considered as a guide for international equity portfolio diversification over different subperiods. In addition, there is evidence of an increasing trend in conditional correlations for Egypt and Turkey, to varying degrees, over time, notably during the post global financial crisis of 2007–2008, thus revealing herding behavior during this period. Overall, investors should be wary of the variation of equity market integration over time before engaging in an investment at the level of portfolio management and diversification. Policymakers must be aware of the remoteness of the current achievements of the Euro–Mediterranean Partnership from the targets set in terms of financial development and economic growth.

Optimal Currency Hedging for International Equity Portfolios

This study explores optimal currency exposures in international equity portfolios through the lens of a modified mean–variance optimization framework. We decomposed the optimal currency portfolio into a “hedge portfolio” that uses a dynamic risk model to minimize equity volatility and an “alpha-seeking portfolio” based on the well-documented currency styles of value, momentum, fundamental momentum, and carry. This method is an integrated and economically intuitive approach to currency management that simultaneously provides lower risk and higher returns than either hedged or unhedged benchmarks. Crucially, the solution is practical, with realistic and implementable leverage, turnover, and tail-risk characteristics.

Integration and risk contagion in financial crises: Evidence from international stock markets

We examine the size of contagion (i.e., integration and co-movement) of weighted portfolios on a global level determining whether the amplification of transmission channels among either emerging or developed financial markets can be affected by different values of a country's characteristics (macro-economic variables) on a regional and global level. To this end, we investigate a large sample of 4577 trading days from sixty-eight international equity markets, taking into consideration both the regional and global setting. The dataset begins on January 3, 2000 and ends on August 31, 2017. The employed methodology concerns a regime-switching generalized autoregressive conditional heteroskedasticity model in accordance with a worldwide regional-local capital asset pricing model. Moreover, two different contagion tests are utilized to examine whether international equity portfolios experienced contagion effects through increased co-movements during periods of financial crises. Our key findings point to distinct shifts in co-movement that are detected either on the regional or global level. The robustness analysis provides more evidence of the contagion effect at the regional level from the US crisis.

The Fallacy of Currency Diversification: How Zero Correlation Can Still Add Risk

The empirical observation is well documented that currency exposure can add risk to an unhedged international equity portfolio. Extending that work, this article uses three manipulations of the standard portfolio risk equation to show (1) why currency acts as implicit leverage in a portfolio and can therefore increase risk, even under the assumption of zero correlation; (2) how, under an additional assumption, the portfolio risk equation reduces to the Pythagorean equation and that, by using that result, a simple proof can show that an unhedged international equity portfolio is always riskier than a hedged one; and (3) how the risk equation can be rearranged to give the “correlation breakeven” that an investor requires to be indifferent to hedging (or not hedging). TOPICS:Currency, developed markets, portfolio construction, risk management