Strategic Asset Allocation - The Impact of Foreign Exposure on Portfolio Choice
Abstract: Plenty of research has been made on strategic asset allocation, but the focus on foreign market exposure is sparse. This paper analyzes how the investor’s portfolio choice is affected when exposed to four foreign assets, one domestic asset, and the risk free interest rate. Two models are developed using dynamic programming for an investor with iso-elastic utility and lognormal asset returns. The problem is derived under the assumption of constant investment opportunities, making the analysis more mathematically convenient. In addition, the investor’s certainty equivalent of wealth is derived and assessed throughout the investment horizon and as diversification possibilities increases with the models. The optimal portfolio choice problem is solved using empirical data between 1996 and 2016. Attained values of the portfolio weights show quite extreme numbers, as many other mean-variance models do. The result provides no clear conclusion regarding the investor´s portfolio choice of risky assets. However, the investor’s certainty equivalent of wealth turned out to be exponentially increasing over time but did not change with diversification possibilities.
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