INTERNATIONAL ASSET ALLOCATION WITH TIME-VARYING RISK - AN ANALYSIS AND IMPLEMENTATION

This paper investigates the problem of optimally allocating funds in a n investment portfolio among major classes of U.S. and Japanese assets , given that the asset risk parameters vary over time. We devise an ec onometric specification in the ARCH/GARCH family to model the evolutio n of the returns covariance matrix and find substantial time variation in both returns variances and correlations. The fitted covariance mat rices are then used to analyze optimal asset allocation portfolios. Th e time patterns in the portfolio weights and risk assessment make sens e: They show the change in the character of the U.S. Treasury bond mar ket in 1979 and the increase in stock market risk in October 1987, for example. However, while the models capture some of the time variation in asset risk parameters, the improvement in portfolio performance is limited. We also examine investment performance under different portf olio constraints, and find that allowing international diversification makes the biggest impact, especially for a U.S. investor. Prohibiting short sales and the hedging of currency risk seem to have little impa ct. We find that post-sample performance of the model deteriorates rel ative to the fixed variance model.