Studies into state-dependent asset pricing models and dynamic asset allocation in international equity markets
Creators: name: Hematizadeh, Roksana
Publisher: name: RMIT University
Year: 2024
Subjects: classificationCode: 350202
subject: Finance

description: One aspect of asset pricing research over the last five decades has focused on the application of asset pricing models to determine an optimal international equity portfolio. However, non-normality in equity market returns and time-varying correlation among international markets have made optimal portfolio selection difficult. For example, the observed high volatility phase in equity market returns is usually associated with extreme negative returns, which causes non-normality in the distribution of market returns. The objective of this the-sis is to develop an appropriately fitted asset pricing model that explicitly captures this salient feature of equity market returns, and that exploits the potential diversification benefits of emerging markets. we use a state-dependent Markov model, which distinguishes between high and low volatility states, to capture time-varying returns in emerging market equity indices. The model is then extended into global asset allocation.<br><br>Time-varying volatility has been identified as a distinguishing feature in financial markets. Previous studies have characterized this feature as regime phases; typically, two regimes signifying bull markets and bear markets have been identified by time-variation in the market risk premium. In this thesis, we employ a state-dependent Markov framework and compare it with mean-variance portfolio optimization. We use time variation in the world market risk premium to identify market phases and study the explanatory power of the model during phase changes in emerging markets. We investigate the use of a macroeconomic variable as a state predictor and examine dynamic linkages between emerging market returns and the macroeconomic variable. We then implement these models in a dynamic asset allocation strategy for portfolio optimization. First, we find that emerging markets exhibit time-varying volatility depending on the world market phases, and the state-dependent Markov models offer superior in-sample estimates of expected returns compared to alternative models. Second, the time-varying nature of as-set returns potentially adds value to portfolio performance and provides diversification benefits for international investors. Third, the state-dependent model indicates that the down-side risks of emerging markets will be offset by their outperformance during normal times. The outcomes of this thesis have practical implications for risk assessment of portfolios and asset allocation decisions across emerging markets.<br><br>Finally, we implement a dynamic asset allocation strategy and use emerging equity markets as an alternative asset class. Dynamic asset allocation enables investors and portfolio man-agers to hedge against risk by investing in safer asset classes such as cash and bonds during bad times, and to make optimal decisions during normal times by diversifying portfolios into different equity markets. we find that incorporating models that account for regime phases gives additional insights into return dynamics in emerging markets.