International Asset Allocation and Hidden Regime Switching

We study the strategic asset allocation for an international investor. The recent empirical evidence on the partial predictability of asset returns has renewed theacademic and practical interest in strategic asset allocation. To model time varying returns on stocks, we use a Gaussian regime-switching model. Such an approach is not only supported by a large body of empirical research, but wasalready successfully applied to different portfolio selection problems. We estimate a regime-switching model using MSCI equity indices of US, UK, and Germany, as well as the 1M Eurodollar rates. We find that a Bayesian investor,who assumes a regime-switching model and engages in optimal currency hedging, can effectively improve the risk and return characteristics of her portfolio. This empirical study is embedded into an introduction to correlation breakdown, which can be generated by regime-switching models, and theory onasset allocation