Risk Exposures and International Diversification : Evidence from Ishares

We examine the newly developed international diversification instruments - iShares traded on the American Stock Exchange. Given the fact that iShares can be created and redeemed at will, the daily price of an iShare is expected to be equal to the daily portfolio value of the underlying assets in the home-country market. Therefore, theoretically, iShare pricing should be influenced by the risk from the iShare's home-country market and not the risk from the U.S. market, per se. We evaluate the risk exposure of iShare prices to the U.S. market (non-fundamental effect) as well as the home-country market (the fundamental effect). We find that most iShare returns are significantly influenced by and sensitive to the U.S. market risk. Moreover, the U.S. market appears to be the key permanent driving factor and the home-country market is a pronounced transitory driving force for iShare prices. These findings indicate the presence of limits of international arbitrage for iShares. As a result, the international diversification benefits of iShares become questionable