International Investing: Diversification and Beyond

A fundamental question in international asset pricing is whether a unified system of risks and their prices extends across national borders. Answering it requires looking beneath country indices. Returns on individual stocks from 26 markets reveal the cross-country structure of systematic risks and their prices. Risk Gaps reflect compensated systematic risks unspanned locally; Price Gaps reflect different premia for shared risks. Both are pervasive; their portfolios have positive returns and low cross-country and US-market correlations. The US market’s Sharpe ratio is 0.55; combining it with foreign indices yields 0.41, whereas replacing them with both gap portfolios raises it to 1.20.