The effect of the financial crisis on crossborder equity portfolio diversification

Abstract

This thesis investigates the effect of the recent financial crisis on cross-border equity portfolio diversification using the IMF’s Coordinated Portfolio Investment Survey (CPIS) data from 2001-2011. The analysis on 27 developed nations shows an increasing trend in the total value of their foreign equity holdings from 2001 to 2007, followed by a sudden drop during the financial crisis in 2008. In contrast, the declining trend observed in home bias during the 2001-2007 period is strengthened during the financial crisis. However, the decomposition of the active and passive components of changes in portfolio holdings reveals that the decrease in home bias during the crisis is mainly due to passive changes in portfolio allocation. This implies that the decline in home bias is not attributable to investors actively seeking low correlation foreign securities. The new measure of financial openness used in this study is found to be highly significant and substantially better than conventional measures. In addition, the results suggest that in the long term, optimal diversification considerations such as initial degree of underweight of a country relative to its weight in the global market portfolio, diversification benefits and a common currency have significant positive impact on investors’ international equity portfolio reallocation decisions.