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Tail dependence and diversification benefits in emerging market stocks: an extreme value theory approach

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This article examines tail dependence, the benefits of diversification and the relation between the two for emerging stock markets. We find most emerging equity markets are independent in limiting joint extremes. However, the dependence in finite levels of extremes is still much stronger than the dependence implied by multivariate normality. Therefore, simple correlation analysis can lead to gross underestimation of the chances of joint crashes in multiple markets. Assuming risk-averse investors guarding against extreme losses, diversification benefits are measured for each two-country optimal portfolio by the reduction in quantile risk measures such as value-at-risk and expected shortfall relative to an undiversified portfolio. It is shown that tail dependence measures developed from multivariate extreme value theory are negatively related to diversification benefits and more importantly can explain diversification benefits better than the correlation coefficient at the most extreme quantiles.

Keywords: C40; G00; G11; diversification benefits; emerging markets; extreme value theory; tail dependence

Document Type: Research Article


Affiliations: Supervision Regulation and Credit, Policy Analysis Unit, Federal Reserve Bank of Richmond, Baltimore, MD, USA

Publication date: July 3, 2014

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