DP2962 EMU and Portfolio Diversification Opportunities
This Paper studies the impact of EMU on portfolio diversification opportunities. We find a significant increase in the correlation between stock returns, whether they are computed on the basis of market or sector indices. This is true for two definitions of the pre-convergence and convergence periods. Diversification opportunities within the Euro-area have thus been reduced. The culprit appears to be less the disappearance of currency risk than the convergence of economic structures and/or the homogenisation of economic shocks (across the Euro-15 member states). This evolution should mark the end of pure country allocation strategies within Europe. If these are the alternatives, the increased conformity of stock returns implies that international diversification does not pay: the cost of the home bias within Euroland has been lowered (in some cases to zero). Diversification across both countries and sectors, however, remains the much superior investment strategy, and, in light of this option, the cost of the home bias continues to be significant.
