International Diversification Gains by Bond Maturity: Evidence from an Affine Term Structure Model with Regime Shifts

Dong-Hyun Ahn | Siddhartha Chib | Kyu Ho Kang
Seoul National University, Seoul| Washington University in St. Louis | Korea University, Seoul

Abstract

In this paper we develop and estimate an arbitrage-free multi-factor two-country affine term structure model to investigate the time-series dynamics and determinants of international diversification gains for bonds of different maturities. The model is built upon two novel features: macro-economic factors and regime shifts in the loadings and market prices of factors. We decompose the macro factors and latent state variables into common and local factors, and allow the term structure dynamics to switch over time among four distinct regimes. The most general model in our class, and several special cases of the general model, are each estimated by a carefully articulated Bayesian method. Estimation results on yield curve data for the U.S. and Canada reveal that the conditional correlation between cross-country bond returns is increasing with time to maturity. Moreover, the conditional correlation for shorter maturities varies more dramatically, driven by business cycles asymmetries between the countries. These findings imply that an internationally diversified portfolio of short-term bonds provides a good hedge against large declines in the domestic bond market, and that the expected gains from international diversification are maximized when the business cycles of the countries are misaligned.

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