Small Caps in International Equity Portfolios: The Effects of Variance Risk

Annals of Finance, Forthcoming

Posted: 16 Jan 2008

See all articles by Giovanna Nicodano

Giovanna Nicodano

University of Turin - Department ESOMAS; Collegio Carlo Alberto; CEPR; EGCI; Netspar

Massimo Guidolin

Bocconi University, Dept. of Finance; Bocconi University - CAREFIN - Centre for Applied Research in Finance

Multiple version iconThere are 2 versions of this paper

Date Written: January 12, 2008

Abstract

We show that predictable covariances between means and variances of stock returns may have a first order effect on portfolio composition. In an international asset menu that includes both European and North American small capitalization equity indices,we find that a three-state, heteroskedastic regime switching VAR model is required to provide a good fit to weekly return data and to accurately predict the dynamics in the joint density of returns. As a result of the non-linear dynamic features revealed by the data, small cap portfolios become riskier in bear markets, i.e., display negative co-skewness with other stock indices. Because of this property, a power utility investor ought to hold a well-diversified portfolio, despite the high risk premium and Sharpe ratios offered by small capitalization stocks. On the contrary, small caps command large optimal weights when the investor ignores variance risk, by incorrectly assuming joint normality of returns.

Keywords: Intertemporal portfolio choice, Return predictability, Co-skewness and co-kurtosis, International portfolio diversification

JEL Classification: G11, G15, F30, C32

Suggested Citation

Nicodano, Giovanna and Guidolin, Massimo, Small Caps in International Equity Portfolios: The Effects of Variance Risk (January 12, 2008). Annals of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1083125

Giovanna Nicodano

University of Turin - Department ESOMAS ( email )

Turin, 10134
Italy

HOME PAGE: http://https://www.carloalberto.org/person/giovanna-nicodano/

Collegio Carlo Alberto ( email )

Piazza Arbarello 8
Torino, Torino 10121
Italy
390116705006 (Phone)

HOME PAGE: http://https://www.carloalberto.org/person/giovanna-nicodano

CEPR ( email )

London
United Kingdom

EGCI ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Netspar ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Massimo Guidolin (Contact Author)

Bocconi University, Dept. of Finance ( email )

Via Roentgen, 1
2nd floor
Milan, MI 20136
Italy

Bocconi University - CAREFIN - Centre for Applied Research in Finance

Via Sarfatti 25
Milan, 20136
Italy

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