Documente Academic
Documente Profesional
Documente Cultură
DOI: 10.1002/fut.21941
RESEARCH ARTICLE
1
Finance Center Muenster, University
of Muenster, Universitätsstr.
Variance‐covariance risk of the exchange rate is highly relevant for interna-
14‐16, Muenster, Germany tional investors. This paper addresses optimal asset allocation with stochastic
2
Chair of Banking and Financial Control, variances and covariances in a Wishart Affine Stochastic Correlation (WASC)
University of Bamberg, Bamberg,
model in incomplete and complete markets. We show that the (hedging)
Germany
demand for exchange rate variance‐covariance risk can differ significantly
Correspondence between international investors. Local correlations with the exchange rate can
Matthias Muck, Chair of Banking and
affect the utilities of international investors differently while the impact of
Financial Control, University of Bamberg,
Kärntenstr. 7, 96045 Bamberg, Germany. correlations between stocks can be symmetric. Depending on the current local
Email: matthias.muck@uni-bamberg.de exchange rate correlations domestic investors can benefit more or less than
foreign investors from international trading.
KEYWORDS
International asset allocation, stochastic correlation, Wishart processes, dynamic trading strategies,
derivatives
JEL CLASSIFICATION
G11, G13
1 | INTRODUCTION
Empirical evidence suggests that return variances and return correlations are stochastic, and that stochastic second
moments are priced. This has been documented within the stock market, across asset classes, and also on international
markets.1 Stochastic second moments have far‐reaching implications for the asset allocation of investors because
expected returns and risk exposures are no longer deterministic, and investment opportunity sets become stochastic.
While stochastic variances have attracted a lot of attention in the literature, approaches to the modeling of stochastic
correlations are relatively new. Within the class of affine models, so‐called Wishart processes allow to specify the joint
dynamics of variances and covariances directly.2 Examples in the literature on portfolio choice are Buraschi, Porchia
and Trojani (2010) and Da Fonseca, Grasselli and Ielpo (2011) who consider the analytically tractable Wishart Affine
Stochastic Correlation (WASC) model.
In this paper we study the asset allocation of international investors. We are interested in how stochastic covariances
and stochastic correlations affect the portfolio choice of domestic and foreign investors. We use a Wishart process to
model the variances and covariances of domestic and foreign stock markets and the foreign exchange rate, and compare
the optimal asset allocation decisions of domestic and foreign investors. Furthermore, we consider benefits from
international trading and compare utility improvements of domestic and foreign investors in particular for different
levels of correlation.
1
Bollerslev, Engle and Wooldridge (1988), Longin & Solnik (1995), Ball & Torous (2000) and Goetzmann, Li and Rouwenhorst (2005) document that international market correlations vary dynamically
over time. Moreover, Driessen, Maenhout and Vilkov (2009) find that correlation risk is priced based on index and individual option prices. The results provided by Krishnan, Petkova and Ritchken
(2009) and Driessen, Maenhout and Vilkov (2012) imply a sufficiently large, negative risk premium for correlation risk. Further studies that deal with the pricing of variance and correlation risk are
Hollstein & Simen (2017), Buss, Schoenleber and Vilkov (2018).
2
Wishart processes were first studied by Bru (1991). Gourieroux (2006) and Da Fonseca, Grasselli and Tebaldi (2007) study the pricing of derivative claims in Wishart frameworks.
The analysis is done both in an incomplete market where the investors can only trade stocks and bonds, and in a
complete market. In a complete market arbitrary exposures to variance‐covariance risk can be attained by trading
derivatives. As it is, for example, discussed by Liu & Pan (2003) this can lead to significant utility improvements for
investors. Mathematically, the particular types of contracts that complete the market do not matter as long as the
derivatives provide an exposure to variance‐covariance risk. In practice, though, it might be advantageous to trade
derivatives whose prices are directly connected to elements of the variance‐covariance matrix. Natural candidates to
trade stock and exchange rate variance risk are stock options and exchange rate options. Quanto contracts and options
on several assets provide an exposure to covariance risk. Besides options, one might also trade futures and swaps on
variances, covariances, and correlations. An advantage of the WASC model is that its affine structure results in quasi
closed form solutions for standard derivatives which allow for an efficient calculation of prices and Greeks. In practice,
this facilitates the application of the model discussed in this paper.
Our paper makes several contributions. First, we consider the joint dynamics of foreign and domestic stock prices
in their local currencies and the (direct) exchange rate when variances, covariances, and correlations are stochastic.
Given this starting point, we derive the investment opportunity sets of domestic and foreign investors who can trade in
international stocks and bonds. The stochastic variance‐covariance matrix is driven by a Wishart process.3
Second, we determine the optimal portfolios of international investors and their utility gains from trading
international stocks and bonds. We assume that investors have constant relative risk aversion (CRRA). While the
demand for stocks is similar for domestic and foreign investors, the demand for foreign bonds – which allow to trade
exchange rate risk – differs significantly between the investors. We also find that the benefits from international trading
are different for domestic and foreign investors. Utility gains depend on the current levels of variances and correlations.
In our example, both certainty equivalent returns increase in the correlation between the stocks, but decrease in the
correlations between the stocks and the exchange rate. Furthermore, the difference between the certainty equivalent
returns can change sign depending on the latter correlations.
Third, we assess the impact of market completion, that is, we consider a market in which international investors have
access to derivatives. Investors can disentangle stock and bond market risk from variance‐covariance risk and exploit risk
premia for stochastic variances and covariances. In our numerical example we find that, in contrast to, for example, the
exposure to the covariance between the stocks, the exposures to the covariance between stocks and the exchange rate are
significantly different and even change sign. The benefits from trading depend on the stochastic correlations. As in the
incomplete market, changes in stock correlations have a symmetric impact on domestic and foreign investors, while changes
in the correlation between stocks and exchange rates might have different consequences.
Our paper is related to several strands of the literature. Following Merton (1969, 1971, 1973) numerous papers deal
with asset allocation problems that take additional risk factors like stochastic volatility or jumps into account. Examples
include Liu, Longstaff and Pan (2003), Chacko & Viceira (2005) and Liu (2007). The implications of market
completeness are explored by, for example, Liu & Pan (2003), Branger, Schlag and Schneider (2008), Muck (2010),
Egloff, Leippold and Wu (2010) and Da Fonseca et al. (2011). Furthermore, Branger, Muck, Seifried and Weisheit (2017)
consider the impact of jumps in variances and covariances in a WASC model for stocks.
Alternatives to the WASC model exist in the literature as well. For example, Engle (2002) proposes the Dynamic
Conditional Correlation (DCC) model. This approach facilitates the econometric estimation of the dynamics of the
correlation matrix. However, in this framework we cannot distinguish between complete and incomplete markets.
Moreover, the pricing of derivatives is more involved. Another possibility is to consider latent state variables (different
from a Wishart process) to describe the variances and covariances. This is, for example, the case in the multi‐Heston
model of De Col, Gnoatto and Grasselli (2013). The multi‐Heston models also results in quasi closed form solutions for
derivative prices. However, covariances are usually not represented by distinct state variables in this approach, but are
driven by the same state variables that determine the variances.
Our paper is also related to the literature on international asset allocation and the benefits from international
investing. Empirical evidence on gains from international equity diversification is provided by, among others, Kaplanis
& Schaefer (1991), Bekaert & Urias (1996) and Li, Sarkar and Wang (2003). In the spirit of Adler & Dumas (1983), a
number of papers study the implications of international asset allocation in dynamic models.4 Lioui & Poncet (2003)
3
Our setup nests the special case in which stock prices and exchange rates are driven by a WASC model.
4
Adler & Dumas (1983) show that international portfolio selection is closely related to portfolio choice problems under inflation risk. The latter usually consider real prices obtained from dividing
nominal prices by a price index, which is identical to dividing prices given in a measurement currency by the exchange rate. Examples for models with inflation risk are Brennan & Xia (2002) and
Munk, Sørensen and Nygaard Vinther (2004).
130 | BRANGER ET AL.
analyze international asset allocation with interest rate risk. Smedts (2004) explores the impact of eliminating the
exchange rate on international portfolios. Similar to our framework, she assumes that investors can trade domestic and
foreign stocks and bonds. Larsen (2010) analyzes a dynamic asset allocation model and shows that investors suffer a
loss from not investing internationally. In contrast to these studies, our focus is on stochastic variances and correlations
in an international market. Ang & Bekaert (2002) study the impact of changing correlations caused by regime switches
in an international asset allocation model. Similarly, Escobar, Ferrando and Rubtsov (2015) study an international
Principal Component Stochastic Volatility (PCSV) model. Our model differs from these approaches as we assume that
the joint dynamics of return variances and correlations are driven by a diffusion Wishart process.
The remainder of the paper is organized as follows: Section 2 introduces the model. In Section 3 we discuss
the asset allocation problem for domestic and foreign investors when markets are incomplete. In Section 4 we calibrate
the model and analyze optimal portfolios as well as benefits from trading in a numerical example. Section 5 deals with
the investment problem when markets are complete. Section 6 concludes.
2 | THE M O DE L
We consider an arbitrage‐free economy in continuous‐time with two countries, the domestic and the foreign one. The
exchange rate is quoted in direct terms, that is, it denotes the amount of the domestic currency that must be paid for one
unit of the foreign currency. For convenience and to simplify the exposition, we call the domestic country USA (with
currency USD) and the foreign country Europe (with currency EUR).
In each country, there is a locally risk‐free money market account and a risky stock. The investors have access to
domestic and foreign financial markets and can thus trade all four assets. A similar setup has been studied by Adler &
Dumas (1983). In line with empirical evidence, we extend their approach by introducing stochastic variances and
stochastic covariances. We follow Buraschi et al. (2010) and Da Fonseca et al. (2011) and rely on the WASC model. This
model considers a state matrix which can be interpreted as variance‐covariance matrix of the asset returns. This allows
to model variance‐covariance risk directly.
In the following we discuss the model for asset returns. We proceed as follows. In Section 2.1 we introduce the model
for international equity and exchange rate returns. Section 2.2 derives the investment opportunity sets faced by a
domestic (US) and a foreign (EU) investor. Section 2.3 defines international risk premia.
where diag(VtMarket ) is a diagonal matrix with the elements of the price vector V Market on the main diagonal. Z ∈ 3 is a
vector Brownian motion, μtMarket denotes the expected returns, and X ∈ 3 × 3 drives the variance‐covariance matrix of
returns. Moreover, the matrix α ∈ 3 × 3 is constant.
The matrix X follows the Wishart‐process
where B ∈ 3 × 3 is a matrix‐valued Brownian motion. Ω, M , Q ∈ 3 × 3 are square matrices, and we assume that Ω is
invertible. The Wishart process describes the dynamics of positive semi‐definite matrices. It was first analyzed by Bru
(1991), and represents the matrix‐analogue of the Cox, Ingersoll and Ross (1985) process. Its long‐run average X∞
follows from
Throughout we require that ΩΩ′ = kQ′Q for k > 2, which guarantees that X is positive semi‐definite.5
The variance‐covariance matrix of stock and exchange rate returns is given by Y Market = αXα′.6 The elements of the
correlation matrix ρ̄ ∈ 3 × 3 of returns are
YtMarket
, ij
ρt̄ , ij ≡ , (5)
YtMarket
, ii YtMarket
, jj
where Yij and ρ̄ij are the elements {i , j} of Y and ρ̄, respectively. The Wishart process thus allows not only for stochastic
variances and covariances, but also for stochastic correlations.
Our model can also capture non‐zero correlations between returns and return variances which determine the shapes
of the volatility smiles. The Brownian motions Z and B which drive returns and their variance‐covariance matrix,
respectively, are related via
with ρ ∈ 3 such that ρ′ρ ≤ 1. W ∈ 3 is a vector Brownian motion independent of B . The correlation between the
return dViMarket ∕ViMarket and its variance Yii (leverage) is given by
dVtMarket (αQ′ρ)i
Corr ⎡ ⎤
,i
⎢ V Market , dYt , ii⎥ = (αQ′Qα′)ii
. (7)
⎣ t,i ⎦
In contrast to the return correlations, which are stochastic, the correlations between asset returns and their local
variances are constant.
Lemma 1 From the perspective of the US investor, the dynamics of the risky securities denoted in USD are given by
5
The rather strong condition on Ω is most commonly used in the relevant portfolio choice literature (see, e.g., Leippold & Trojani (2010) or Buraschi et al. (2010)). Cuchiero, Filipović, Mayerhofer and
Teichmann (2011) show that it can be relaxed to ΩΩ′ − 2Q′Q ∈ S3+ , where S3+ is the cone of symmetric, positive semi‐definite matrices in 3 × 3 .
6
In the special case when α is the identity matrix, Equations 1 and 2 characterize the Wishart Affine Stochastic Correlation (WASC) model in which the variance‐covariance matrix of returns is Y = X .
132 | BRANGER ET AL.
where
⎛1 0 0⎞
βUS = ⎜ 0 1 1 ⎟ α.
⎝0 0 1⎠
Y US = βUSXβUS′.
EU
Proof The USD prices of the European stock and bond are given by S EU = S EU *F and PtEU = e r tFt , respectively.
Equation (1) and an application of Itô’s Lemma yields Equation (8). The variance‐covariance matrix follows
immediately. □
The expected return μUS will be given in Section 2.3 where we discuss the market prices of risk. As above, the return
correlations are stochastic, while the correlations between returns and their variances are constant.
Lemma 1 shows that our model nests a WASC model for the USD denominated returns. In this case the matrix βUS is
equal to the identity matrix, the matrix α is
−1
⎛1 0 0⎞ ⎛1 0 0⎞
α = ⎜ 0 1 1 ⎟ = ⎜ 0 1 − 1⎟ ,
⎝0 0 1⎠ ⎝ 0 0 1⎠
Lemma 2 From the perspective of the EU investor, the dynamics of the risky securities denoted in EUR are given by
where
⎛ 1 0 − 1⎞ ⎛ 1 0 − 1⎞
β EU = ⎜ 0 1 0 ⎟ α = ⎜ 0 1 − 1⎟ βUS .
⎝ 0 0 − 1⎠ ⎝ 0 0 − 1⎠
Y EU = β EU Xβ EU ′.
S US e rUSt
Proof The EUR prices of the US stock and bond are given by SUS * = F and PtUS * = F . Equation (1) and an
t
application of Itô’s Lemma yields Equation (9). The variance‐covariance matrix follows immediately. □
BRANGER ET AL. | 133
dMtUS
= −r US dt − tr (ηUS ′ Xt dBt ) − ξ US′ Xt dWt . (10)
MtUS
where the constant coefficients ηUS ∈ 3 × 3 and ξ US ∈ 3 describe the exogenously specified market prices of risk for B
and W , respectively.8
The risk premiums of the assets follow from the covariances between the asset returns and the pricing kernel. From
the perspective of the US investor, the risk premiums for the stocks and the EU bond (in USD) are
where
This gives the expected return μtUS of the USD denominated returns in Equation (8).
Under the equivalent risk neutral measure US the state matrix X again follows a Wishart process
Xt dBt Q + Q′dBt
US US′
dXt = (ΩΩ′ + ℳUSXt + Xt ℳUS′)dt + Xt , (13)
where ℳUS = M − Q′ηUS′. The instantaneous risk premium for variance‐covariance risk results from the dynamics of
the state matrix X under and US in Equations 2 and 13 and it is given by
1
(Et [dYtUS] − Et [dYtUS]) = βUS (Xt ηUS Q + Q′ηUS′Xt ) βUS′.
US
CovRPtUS ≡ (14)
dt
Next, we address the pricing kernel from a European perspective. The corresponding European pricing kernel MtEU
is given by
MtUS Ft
MtEU = . (15)
F0
By a standard argument the drift of the exchange rate in Equation (1) is given by
dM US dF ⎤
μ3Market = r US − r EU − COV ⎡ US , .
⎢
⎣ M F ⎥
⎦
dMtEU
= −r EU dt − tr (η EU ′ Xt dBt ) − ξ EU ′ Xt dWt , (16)
MtEU
where
7
See, e.g., Da Fonseca et al. (2007).
8
The specification of the market prices of risk guarantees analytical tractability for the solution to the portfolio allocation problem. Generalized market prices of risk in Wishart‐based models are
suggested by Chiarella, Hsiao and To (2011) or Gruber, Tebaldi and Trojani (2014).
134 | BRANGER ET AL.
and δ = (0 0 1) ′. From the perspective of the EU investor, the risk premia on the US stock, the EU stock, and the US
bond (in EUR) are thus
where
1
(Et [dYtEU ] − Et [dYtEU ]) = β EU (Xt η EU Q + Q′η EU ′Xt ) β EU ′
EU
CovRPtEU ≡ (20)
dt
Finally and for the sake of completeness, we note that the expected returns in Equation (1) are affine in the state
matrix X and given by
US US US
⎛ r + (β Xt Λ )1 ⎞
μtMarket = ⎜ r EU + (β EU Xt ΛEU )2 ⎟.
⎜ r US − r EU + (βUSX ΛUS ) ⎟
⎝ t 3⎠
The previous section established the international setup with stochastic variances and stochastic covariances. In the
next step, we study the impact of these additional sources of risk on international portfolio choice and subsequently on
the (different) benefits of international investors that result from international stock market participation. In
Section 3.1, we derive the wealth dynamics from the perspective of both investors. Section 3.2 solves the portfolio
planning problem of the domestic and foreign investor where we assume constant relative risk aversion.
dΠtc
= [r c + ωtc′ β cXt Λc]dt + ωtc ′β c Xt dZt (21)
Πtc
where c ∈ {US , EU }.
Assume that US and European investors pick the same exposures ω̄t = β EU ′ωtEU = βUS′ωtUS to Xt dZt . Then it
holds that
BRANGER ET AL. | 135
dΠUSt dΠtEU
− = [r US − r EU + (ω̄t ) ′Xt (ΛUS − ΛEU )] dt
ΠUS
t ΠtEU
(22)
= [r US − r EU + ωtUS ′YtUS δ ] dt
= [r EU − r US − ωtEU ′YtEU δ ] dt .
The difference of expected returns depends on (i) the interest rate differential, (ii) the covariances between stock returns
and the exchange rate Ytc,13 and Ytc,23, and (iii) the variance of the exchange rate Ytc,33.
c 1−γ
max E ⎡ (ΠT ) ⎤ c ∈ {US , EU }, (23)
ωtc ,0 ≤ t ≤ T ⎢⎣ 1−γ ⎥ ⎦
with relative risk aversion 0 < γ ≠ 1.9 The solution to the investment problem and the optimal portfolio strategy are
summarized in the next proposition.
(Πc )1 − γ
c (t , Πc , X ) = exp{tr [Ac (τ ) Xt ] + C c (τ )}. (24)
1−γ
1 c
ω ct̃ = β c′ωtc = (Λ + 2Ac (τ ) Q′ρ), (25)
γ
where τ = T − t . The functions Ac and C c solve the system of ordinary differential equations
∂Ac (τ ) 1−γ
= Ac (τ ) Γ c + Γ c′Ac (τ ) + 2Ac (τ ) Q′ ⎜⎛ + ρρ′⎟⎞ QAc (τ ) + ζ c (26)
∂τ ⎝ γ ⎠
∂C c (τ )
= (1 − γ ) r c + tr [ΩΩ′Ac (τ )] (27)
∂τ
1−γ
Γc = M + Q′ρ Λc′
γ
1−γ c c
ζc = Λ Λ ′.
2γ
Proof Optimization with respect to the exposures ω c̃ = β c′ωc is a special case of the portfolio optimization
problem studied in Branger et al. (2017). A proof can be found in that paper and the references cited therein. □
9
We do not consider the special case γ = 1 representing the log‐investor. An optimization problem with a WASC model with logarithmic utility is treated by Bäuerle & Li (2013).
136 | BRANGER ET AL.
The time dependent functions Ac are provided in Appendix A and C c (τ ) follows by direct integration of
Equation (27). The functions Ac measure the sensitivity of the indirect utility function with respect to the state matrix
X . The more different AUS and AEU , the more different the impact of changes in the state matrix on the utility. Note that
the indirect utility depends on ΛUS and ΛEU , respectively, which capture the market prices of Z ‐risk. The risk premia for
variance‐covariance risk have no impact on the solution of the investment problem and on the optimal utility, since the
investors cannot trade variance and covariance risk due to market incompleteness.
Proposition 1 gives the optimal portfolios of the European and the US investor
1 c −1 c
ωtc = (β ′) (Λ + 2Ac (τ ) Q′ρ). (28)
γ
The optimal portfolio comprises a myopic (speculative) demand and a hedging demand. The myopic demand is driven
by the risk premia Λc of the tradeable assets. Given the definitions of βUS , β EU , ΛUS , and ΛEU , the myopic demand of
domestic and foreign investors for stocks is identical.
The hedging demand is
2 c −1 c 2 2
ωtc, hedge = (β ′) A (τ ) Q′ρ = (β c′)−1Ac (τ )(β c )−1β cQ′ρ = A*c (τ ) Q *c′ρ , (29)
γ γ γ
where we define
It is driven by the desire of the investor to hedge unanticipated changes of the variance‐covariance matrix Y c over the
investment horizon. Note that it holds that
Hence, the hedging demand depends on the impact A*c of Y c on the indirect utility function in Equation (24) as well
as on the covariance between the returns of (traded) assets and (non‐traded) variance‐covariance risk, which is driven
by Q *c . We follow Buraschi et al. (2010) and decompose the hedging demand into
*c (τ )(Q *c ′ρ)1 ⎞
⎛ A11 *c (τ )(Q *c ′ρ)2 + A13
⎛ A12 *c (τ )(Q *c ′ρ)3 ⎞
2⎜ c 2
ωtc, hedge = A * (τ )(Q *c ′ρ)2 ⎟ + ⎜ A12 *c (τ )(Q *c ′ρ)3 ⎟.
*c (τ )(Q *c ′ρ)1 + A23 (31)
γ ⎜ 22 ⎟ γ⎜ ⎟
*c c′ *c c′ *c c′
⎝ A33 (τ )(Q * ρ)3 ⎠ ⎝ A13 (τ )(Q * ρ)1 + A23 (τ )(Q * ρ)2 ⎠
The first vector summarizes the hedging demand due to changes in variances while the second vector is the hedging
demand due to changes in covariances ( Aii*c and Aij*c , i ≠ j are the sensitivities with respect to variances Yiic and
covariances Yijc , respectively). The hedging demand vanishes for (Q *c′ρ) = 0.
In this section we provide a numerical example which highlights the importance of variance‐covariance risk for optimal
portfolios and investors’ utility. In Section 4.1 we calibrate the model using data on the S&P 500 index, the Euro Stoxx
50 index, and the USD/EUR exchange rate. Section 4.2 contains the numerical results.
BRANGER ET AL. | 137
Interest rates
r US 0.00
r EU 0.00
State variables
X0 M
⎛ 0.0282 0.0173 0.0033 ⎞ ⎛−2.7500 0.1000 0.0100 ⎞
⎜ 0.0173 0.0297 0.0092 ⎟ ⎜ 0.1000 −2.7500 0.0100 ⎟
⎝ 0.0033 0.0092 0.0120 ⎠ ⎝ 0.0100 0.0100 −4.0000 ⎠
Q ρ
⎛ 0.2500 0.0800 0.0100 ⎞ ⎛−0.5000 ⎞
⎜ 0.0800 0.2500 0.0600 ⎟ ⎜−0.4000 ⎟
⎝ 0.0100 0.0600 0.2000 ⎠ ⎝ 0.2500 ⎠
k 2.2000
Market prices of risk
ΛUS ⎛ 0.9963 ⎞ ΛEU ⎛ 0.9963 ⎞
⎜ 1.3510 ⎟ ⎜ 1.3510 ⎟
⎝−0.4701⎠ ⎝−1.4701⎠
Note. The table gives the base case parametrization for our model. The matrix X0 is set to its long‐run mean.
US perspective EU perspective
Long run second moments
long‐run volatilities
⎛ 0.1681 ⎞ ⎛ 0.1838 ⎞
⎜ 0.1722 ⎟ ⎜ 0.1527 ⎟
⎝ 0.1098 ⎠ ⎝ 0.1098 ⎠
long‐run correlations
⎛ 1 0.5982 0.1763 ⎞ ⎛ 1 0.6026 0.4360 ⎞
⎜ 0.5982 1 0.4865 ⎟ ⎜ 0.6026 1 0.1702 ⎟
⎝ 0.1763 0.4865 1 ⎠ ⎝ 0.4360 0.1702 1 ⎠
leverage
⎛−0.5882 ⎞ ⎛−0.5721 ⎞
⎜−0.4642 ⎟ ⎜−0.5931 ⎟
⎝ 0.1005 ⎠ ⎝−0.1005 ⎠
Risk premia
excess returns
⎛ 0.0500 ⎞ ⎛ 0.0488 ⎞
⎜ 0.0530 ⎟ ⎜ 0.0459 ⎟
⎝ 0.0100 ⎠ ⎝ 0.0020 ⎠
Note. The table gives the long run second moments and risk premia as seen from the US and EU perspective. The first and second row of the vectors and
matrices refer to US and EU stocks, while the third row refers to the foreign bond (EU and US bond from the US and the EU perspective, respectively). The first
panel provides return volatilities, return correlations and the correlation between returns and their variances (leverage). Leverages are calculated along the lines
of Equation (7). The second panel gives the expected excess returns on the assets.
138 | BRANGER ET AL.
(a)
(b)
F I G U R E 1 Optimal portfolio holdings. The figure shows optimal portfolio weights for the US investor (left column) and the European
investor (right column). Hedging demands are calculated as percentage of the myopic demand, both for the US investor (left column)
and the European investor (right column). Unless stated otherwise, we set γ = 5 and τ = 1 year [Color figure can be viewed at
wileyonlinelibrary.com]
Table 2 summarizes the resulting moments. It also contains the stock and bond risk premia which are exogenously
specified for the USD‐returns. The premia from the perspective of the EU investor follow from the European pricing
kernel. Risk premia are chosen to lie in a generally accepted range. Moreover, we set interest rates (and thus the interest
rate differential) equal to zero.
To analyze the economic benefits from trading, we rely on certainty equivalent returns (CER) which are defined as
(ΠTc )1 −γ ⎤
u (Πc0 e CERT T ) = E ⎡
c
⎢ 1 − γ ⎥,
⎣ ⎦
where c ∈ {US , EU }. They give the return per year for which an investor is indifferent between receiving this
(deterministic) return and the (stochastic) terminal wealth of the risky trading strategy.11 Since interest rates are assumed to
10
For a discussion on the impact of correlation between stock returns and variances (leverage) and the slope of the volatility smile see Heston (1993) for the single stock case and, for example, Branger
& Muck (2012) for a model with Wishart processes.
11
This benchmark measure is thus closely related to the certainty equivalent wealth which is, for example, considered by Liu & Pan (2003).
BRANGER ET AL. | 139
be zero, the CER of a domestic bond‐only investor is zero and the CER can be interpreted as the utility gain from trading in
the risky assets.12 Both investors are assumed to have identical risk aversion (γ = 5) and a 1‐year investment horizon.
5 | ASSET ALLO C A TI O N I N CO M P L ET E M A R K ET S
As it is, for example, highlighted by Liu & Pan (2003), the benefits from trading can improve substantially when investors also
have access to the derivatives market. The prices of financial derivatives in general depend on stock variances and covariances.
12
As noted above, differences between certainty equivalent returns are not affected by the choice of (deterministic) interest rates.
13
An overview is provided, for example, in Branger et al. (2017). As compared to Buraschi et al. (2010), however, the hedging demands reported in Figure 1 are small.
140 | BRANGER ET AL.
F I G U R E 2 Certainty equivalent returns and correlation. The figure shows the certainty equivalent returns (CER) as functions of local
return correlations. The solid lines give the US investor’s CER, the dashed lines refer to the CER of the European investor. The investment
horizon is τ = 1 year, the relative risk aversion is γ = 5 [Color figure can be viewed at wileyonlinelibrary.com]
Hence, they can be used to get an exposure to the state matrix X . This allows investors to disentangle stock market risk from
variance‐covariance risk. They can then also earn the premia on variance and covariance risk, and they can hedge the risk in
second moments better, which leads to higher certainty equivalent returns.
The purpose of this section is to analyze the impact of stochastic covariances and correlations on domestic and
foreign investors when markets are complete. In Section 5.1 we compare their investment opportunity sets and state the
optimal portfolios. In Section 5.2 we present a numerical example.
dΠtc
= r c dt + tr [(θtB, c ) ′ (Xt ηc dt + Xt dBt )] + (θtW , c ) ′ (Xt ξ c dt + Xt dWt ). (32)
Πtc
BRANGER ET AL. | 141
Proof For the given exposures θtB, c and θtW , c the expected excess returns over the risk free rate of interest follow
directly from the pricing kernels (10) and (16). For further details, see also, for example, Branger et al. (2017). □
B W
Assume that US and EU investors pick the same exposures θt̄ = θtB, US = θtB, EU and θt̄ = θtW , US = θtW , EU to the risk
factors. The difference between the returns from the perspective of a European and a US investor is
dΠUS dΠtEU B
t
US
− EU
= {r US − r EU + tr [(θt̄ ) ′Xt (ηUS − η EU )] + (θW
̄ )′Xt (ξ US − ξ EU )} dt
Πt Πt (33)
= {
r US − r EU + tr [θtB, US′ ( )
βUS −1YtUS δρ′ ]+ θtW , US′ ( )
βUS −1YtUS δ 1 − ρ′ρ } dt
As in the incomplete market case, investors earn different expected returns for identical factor exposures. The
difference depends on (i) the interest rate differential, (ii) the covariances between stocks and the exchange rate (YtUS
,13
and YtUS US
,23), and (iii) the variance of the exchange rate (Yt ,33).
As in the incomplete market, we assume that the US and the European investor have identical CRRA preferences
and maximize the expected utility from terminal wealth. The solution to the investment problem is summarized in the
next Proposition.
(Πc )1 − γ
c (t , Πc , X ) = exp {tr ( c (τ ) Xt ) + c (τ )},
1−γ
1 c
θtB, c = (η + 2 c (τ ) Q′)
γ
1
θtW , c = ξc
γ
∂ c (τ ) 2
= c (τ ) Γ c + Γ c′ c (τ ) + c (τ ) Q′Q c (τ ) + ζ c (34)
∂τ γ
∂ c (τ )
= (1 − γ ) r c + tr [ΩΩ′ c (τ )] (35)
∂τ
1−γ
Γc = M + Q′ηc ′
γ
1−γ c c
ζc = [η η ′ + ξ cξ c′].
2γ
Proof This is a special case of the portfolio optimization problem treated in Branger et al. (2017). A proof can be
found in that paper and the references cited therein. □
The solutions of Equations 34 and 35 are stated in Appendix A. As in the incomplete market, the optimal demand
comprises myopic and hedging components. The constant myopic demand follows from the market prices of risk for dB
and dW . The hedging demand depends on the matrix c (τ ), which denotes the sensitivity of to changes in X , and on
the matrix Q , which captures the exposure of X to dB .
142 | BRANGER ET AL.
US perspective EU perspective
Market prices of risk
ηUS ⎛−0.7847 0.0557 0.1447 ⎞ η EU ⎛−0.7847 0.0557 0.1447 ⎞
⎜−0.2309 −0.7429 −0.0876 ⎟ ⎜−0.2309 −0.7429 −0.0876 ⎟
⎝−0.0227 −0.2442 −0.0240 ⎠ ⎝ 0.4773 0.1558 −0.2740 ⎠
ξ US ⎛ 0.8125 ⎞ ξ EU ⎛ 0.8125 ⎞
⎜ 1.3220 ⎟ ⎜ 1.3220 ⎟
⎝−0.7891⎠ ⎝−1.5154 ⎠
Variance‐covariance risk
premia
1 1
⎛−0.0150 −0.0120 −0.0025 ⎞ ⎛−0.0146 −0.0083 −0.0013 ⎞
US EU
(Et [dYtUS] − Et [dYtUS]) (Et [dYtEU ] − Et [dYtEU ])
dt ⎜−0.0120 −0.0150 −0.0045 ⎟ dt ⎜−0.0083 −0.0083 0.0012 ⎟
⎝−0.0025 −0.0045 −0.0015 ⎠ ⎝−0.0013 0.0012 −0.0020 ⎠
Note. The table gives the additional parameters and risk premia as seen from the US and EU perspective for the complete market analysis.
Proposition 2 gives the optimal exposures to the risk factors B and W . We are, however, mainly interested in the
positions in stocks and bonds and in the positions in variance and covariance risk. Therefore, we follow Branger et al.
(2017) and re‐write the wealth dynamics given in Lemma 4 as
dΠtc
= ΘV , c ′diag(Vtc )−1dVtc + tr [ΘY , c ′dYtc ], (36)
Πtc
1 1
ΘVt , c = (β c′)−1ξ c (37)
γ 1 − ρ′ρ
1 c −1 ⎡ c 1 ⎤ 1
ΘYt , c = (β ′) ⎢η − ξ cρ′⎥ (Q′)−1 (β c )−1 + (β c′)−1 c (τ )(β c )−1. (38)
2γ 1 − ρ′ρ γ
⎣ ⎦
The demand for the assets is driven by the market prices of risk and coincides with the myopic demand. The demand
for variance‐covariance risk has both a myopic component and a hedging component, where the latter depends on c .
14
As in Branger et al. (2017), the coefficients ηc and ξ c have to meet additional conditions to ensure that ΘY , c is symmetric. They can always be chosen such that these conditions hold true. The reason
is that, given the premia on stocks, bonds, and second moments, the coefficients ηc and ξ c are not unique. While we can basically use any solution for ηc and ξ c which results in the given risk premia,
there is one specific solution which is needed for Equations 37 and 38 to hold.
15
See Footnote 14.
16
Pan (2002), Bakshi & Kapadia (2003a,2003b), Carr & Wu (2009) or, for international markets, Londono & Zhou (2017) consider negative variance risk premia. Krishnan et al. (2009), Driessen et al.
(2012), Mueller, Stathopoulos and Vedolin (2017) and Hollstein & Simen (2017) report significantly negative compensations for correlation risk.
BRANGER ET AL. | 143
(a)
(b)
F I G U R E 3 Optimal exposures and certainty equivalent returns (complete market). The figure shows the optimal exposure ΘY , US and
ΘY , EU and the certainty equivalent returns (CER) as a function of the investment horizon τ and local correlations, respectively. The solid
lines refer to the US investor, the dashed lines give the exposure of the European investor. The investment horizon is τ = 1 year and the
coefficient of relative risk aversion is γ = 5 [Color figure can be viewed at wileyonlinelibrary.com]
particular, while the US investor has negative exposures to the covariances of the foreign bond with the stocks and
a positive exposure to the variance of the foreign bond, the opposite holds true for the European investor.
Technically, these observations are in line with Equation (38) which highlights that for identical exposures
investors face different expected returns depending on the variance of the exchange rate as well as covariances
between stocks and the exchange rate. We also look at the exposures to the second moments of stock returns. They
are nearly identical for the domestic and the foreign investor. This is demonstrated for the example of the
correlation between stock returns in Figure 3.
Panel B of Figure 3 gives the certainty equivalent returns when the state matrix X differs from its long term mean.
Local correlations affect the CER in a similar way as in the incomplete market. Again, the CER of both investors
increases in the stock market correlation, while the difference of the CERs stays constant. Furthermore, higher
correlations between stocks and the exchange rate lower the CER of both investors. The size of the impact differs
between the investors in that European investors suffer larger losses than US investors. Similar to the incomplete
market, European investors might even have higher CERs when the correlation between the European stock and the
exchange rate is low, while the opposite holds true when the correlation is high.
144 | BRANGER ET AL.
6 | C ON C LU S I O N
In this paper, we study the optimal asset allocation from an international perspective when variances, covariances, and
correlations between stocks and the exchange rate are stochastic. We derive optimal portfolio strategies from the
domestic and the foreign perspective and study the differences in investors’ benefits from international trading.
We find that correlation risk matters to investors and that the impact of exchange rate risk on domestic and foreign
investors is not necessarily the same. First, positions in foreign bonds differ between investors while their holdings of
stocks are very similar. Second, hedging demands in foreign bonds are different for the investors in the incomplete
market. In the complete market, positions in the variance of the exchange rate and in the covariances between stock
returns and the exchange rate also differ significantly for both investors. Third, benefits from international trading
depend on stochastic correlations. While both investors react in the same way to changes in the correlation between
risky stocks, changes in the correlation between the exchange rate and stock returns again affect the investors
differently and may even change the relative size of the utility gains from trading.
We base our analysis on exogenously specified market prices of risk. An issue for future research is to study the
pricing of variance‐covariance risk in an international equilibrium model. It would also be interesting to apply the
model to the pricing of stock and foreign exchange options which then allows to extract the risk‐neutral dynamics and
thus also the compensations on variance‐covariance risk. Finally, the inclusion of jump risk, as proposed by Leippold &
Trojani (2010), allows to study the different reactions of investors in particular to sudden changes of second moments.
ORCID
Nicole Branger http://orcid.org/0000-0003-0466-6515
Matthias Muck http://orcid.org/0000-0003-2364-9833
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APPENDIX A
Ac (τ ) = ℋ 22
c
(τ )−1ℋ 21
c
(τ ) (A.1)
where
c c
⎜
c
(
1−γ
⎛⎜ ℋ11 (τ ) ℋ12 (τ ) ⎞⎟ ≔ exp ⎢τ ⎛ Γ − 2Q′ + γ ρρ′ Q ⎞ ⎥.
⎡
⎟
⎤
)
⎝ℋ 21 (τ ) ℋ 22 (τ ) ⎠
c c
⎢ ⎜ζc − Γ c′ ⎟⎥
⎣ ⎝ ⎠⎦
c (τ ) = ℱ22
c
(τ )−1ℱ21
c
(τ ) (A.2)
γk
c (τ ) = (1 − γ ) r cτ − tr [lnℱ22
c
(τ ) + Γ c′τ ] (A.3)
2
where
2
⎛⎜ ℱ11 (τ ) ℱ12 (τ ) ⎞⎟ ≔ exp ⎡τ ⎛ Γ − γ Q′Q ⎞ ⎤.
c c c
⎢ ⎥
⎝ ℱ21 (τ ) ℱ22 (τ ) ⎠
c c ⎜ c c′ ⎟
⎢
⎣ ⎝ ζ − Γ ⎠⎥⎦