Does International Diversification Substitute Home Bias : An Application of a Non Parametric Stochastic Dominance Approach

Using non-parametric stochastic dominance approach this paper investigates whether international diversification and home bias inertia are substitutes or complements. More specifically it applies, on a data set consisting of daily closing prices of US stocks and index and Asian and Latin American stock market indices for the period from April 1st to October 29, 2004, Barrett and Donald [6], Monte Carlo and bootstrapped p-values to generate stochastic dominance relationships. Empirical results show that international and domestic diversifications seem to be complementary strategies for American investors since no dominance relationships were revealed. However, substitutability can be shown according to risk aversion degree. For low risk aversion coefficient, domestic diversified portfolios, first-second stochastically dominate global and international diversified portfolios in 70 percent of cases in average. Inversely, for high risk aversion coefficient, globally and internationally diversification strategies are preferred to efficient domestic diversification one. Global diversification behaves more as a substitute than a complement to international major and emerging diversification strategies for risk-adverse American investors.

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