Does firm-level heterogeneity help explain the covariance structure of international stock returns? We extend the prevailing approach in the international diversification literature (Heston and Rouwenhorst 1994), which focuses on country- and industry-level characteristics to explain comovement in international returns. We estimate a factor model that allows for firm-specific exposures to global, country, and industry shocks. Our approach captures observed and unobserved differences across companies, for example, the degree to which they operate internationally or across industries. We find that firm-level heterogeneity matters and can be exploited for successful international diversification strategies.
JEL classification: G11, G15
Keywords: diversification, risk, international financial markets, industrial structure
We wish to thank, without implication, Bernard Dumas, Wayne Ferson, Linda Goldberg, Andrew Karolyi, Ashoka Mody, Cesare Robotti, Geert Rouwenhorst, Jay Shanken, Steve Smith, Dan Waggoner, and participants at the Atlanta Fed, 2003 European Finance Association meetings (Glasgow), Georgia Tech, INSEAD, 2002 LAMES (Saõ Paulo), Spring 2003 System Committee in International Economics, for comments. We are also grateful to Young Kim for excellent research assistance and Iskander Karibzhanov for translating some of our code into C. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta, the Federal Reserve System, or the IMF. Any remaining errors are the authors’ responsibility.
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