Is the Potential for International Diversification Disappearing?∗

Quantifying the evolution of security co-movements is critical for asset pricing and portfolio allocation, and so we investigate patterns and trends in correlations and tail dependence over time using weekly returns for developed markets (DMs) and emerging markets (EMs) during the period 1973-2009. We use the standard DCC and DECO correlation models, but we also develop a nonstationary DECO model as well as a novel dynamic skewed t-copula to allow for dynamic and asymmetric tail dependence. We show that it is possible to characterize comovements for many countries simultaneously. Correlations have significantly trended upward for both DMs and EMs, but correlations between EMs are lower than between DMs. The tail dependence has also increased for both EMs and DMs, but its level is still very low for EMs as compared to DMs. Thus, while our correlation analysis suggests that the diversification potential of EMs has reduced over time, the tail dependence analysis suggests that EMs offer diversification benefits during large market moves. JEL Classification: G12